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The World's Smartest Investors Have Failed

Investors started getting excited about hedge funds in the 1990s, when people like George Soros and Steve Cohen were earning returns of 30% or more, year after year, crushing the market. More funds opened, and their marketing pitch went something like this: We have the best investors in the world, and their returns are not correlated to the rest of the market. We will earn you so much money that we deserve the absurd fees we're going to charge you for it. 

This worked for some funds for some time, but it's become plainly clear in recent years that the biggest bull market was in inflated promises. As a group, hedge funds -- which now manage $2.5 trillion -- have consistently underperformed a basic S&P 500 index fund over the last five years. 

Now a new hedge fund marketing pitch has been born, one I've seen over and over again. It goes like this: Sure, hedge fund managers say, maybe we don't outperform the S&P 500. But that was never our goal. Our goal is to manage risk, offering limited upside while protecting investors' downside with lower volatility than the rest of the market.

But if a hedge fund's goal is to manage downside risk, it shouldn't be compared to the S&P 500 (SNPINDEX: ^GSPC  ) at all. It should be compared to a benchmark that also tries to manage downside risk, like a simple index that invests 60% of its assets in stocks and 40% in bonds. 

Vanguard has a 60/40 index fund with a super-low expense ratio of 0.24%. Here's its returns over the last decade compared to the returns of the average long-short and multistrategy hedge fund: 

Source: S&P Capital IQ, Boomerang Capital, Bloomberg, author's calculations. 

The 60/40 Vanguard fund, which anyone can invest in, opening an account in about four minutes and 26 mouse clicks (I counted), beat the average multistrategy and long-short hedge fund over the last decade. And it did it with lower annual volatility (measured by standard deviation).


Average Annual Return, 2002-2013

Standard Deviation

Vanguard 60/40



Long-Short Hedge Fund



Multistrategy Hedge Fund



So, put all this together. 

  • Hedge funds' selling point used to be superior returns. But that went away.
  • Now their selling point is protecting downside risk. But they don't do that any better than an 60/40 index fund, either.

The results are actually worse than I'm showing here, because the hedge fund returns in this chart are from an index comprising hundreds of funds, which no one can actually invest in. The actual experience of investors in individual hedge funds is more volatile than this chart shows, with some funds doing better and others much worse. 

By almost any metric, the average hedge fund investor would have been better off in Vanguard's 60/40 fund over the last decade.

Maybe the future will look different. You don't need to be too imaginative to picture a world where both stocks and bonds do poorly, which could end the 60/40 portfolio's outperformance over hedge funds. But that's hypothetical. Hedge funds' fees, and their underperformance, are very real, here and now.

Be careful when worshiping the "smart money." 

Read/Post Comments (13) | Recommend This Article (45)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 27, 2014, at 6:15 PM, LQM2 wrote:

    Good article exposing hedge funds for what they machines that sell meaningless exclusivity rather than meaningful alpha. Plus another benefit to Vanguard don't need to worry about the next Bernie Madoff!

  • Report this Comment On January 27, 2014, at 7:21 PM, WayRuss wrote:

    I would like to see some numbers comparing some of the best hedge funds to the 60/40 fund. Why make a claim unless you show the statistics?

  • Report this Comment On January 27, 2014, at 8:30 PM, RichWiner wrote:

    While it may be a marketing ploy for some funds, that goal of managing risk is a valid one. The performance of most stock mutual funds, money managers and even hedge funds is usually compared to the S&P 500. And when the managers underperform, voices from the media and proponents of passive investing say, "Why not just put all of your money in an index fund." To many, that sounds great and many do. The unmentioned problem is that indexes like the S&P 500 and the index funds that track them have an unlimited time horizon. If the index loses 40-50% in a bear market, it doesn't matter. The index has an unlimited time horizon and can wait forever to make up for any losses. Most people can't afford that luxury. I believe there are a lot of people invested in index funds today who will lose a lot of money in the next bear market, at a time when they can't afford to do so and don't have time to make up the losses. Those investors, many of whom may be retirees, will wish they had been invested with one of those underperforming managers who strive to manage downside risk. And after the next bear market, their performance might look a whole lot better relative to the S&P 500 than after two up years without a correction over 4% in more than a year.

  • Report this Comment On January 27, 2014, at 9:08 PM, TMFHousel wrote:


    I agree. But most hedge funds lost a lot of money in 2008. If you click on the link in the article, you'll see that the average equity market neutral hedge fund lost more than 40% in 2008.

    Managing risk and protecting downside is a noble goal in theory. In practice, it's mostly elusive.

    To repeat the thrust of this article, the average hedge fund investor could have earned higher returns with lower volatility and less downside risk in a simple 60/40 index fund.

    Thanks for the comments,


  • Report this Comment On January 28, 2014, at 12:22 AM, chris293 wrote:

    You have to wonder if the individual (a smart one) investor who can move in and out of stocks with little sweat while maintaining a buy and hold stagey overall wouldn't beat most of the other types of investments. It's best if you don't ask me what I really think about other investments.

  • Report this Comment On January 28, 2014, at 10:30 AM, SkepticalOx wrote:

    "I would like to see some numbers comparing some of the best hedge funds to the 60/40 fund. Why make a claim unless you show the statistics?"

    I don't think that question is as relevant as you think it is. The question is, as an investor, can you pick the winning hedge fund managers ahead of time?

  • Report this Comment On January 28, 2014, at 2:48 PM, slotowner wrote:

    I cannot see much justification for hedge funds for most people because of risk. What is inherently more risky, an very liquid index fund which can be traded quickly or a hedge fund which have many restrictions on when you can access you money?

    Hedge funds would need to justify a much higher LT rate of return to negate their bad liquidity risk. Even if you cherry pick the date to show the best variance I don't think the hedge funds generates enough of a return to justify it higher risk vs. a very common investing baseline. Especially since they in general have been poor at being a consistent hedge.

  • Report this Comment On January 31, 2014, at 3:00 PM, cmalek wrote:

    Because of their loads and maintenance fees hedge funds need to generate at least couple of percentage points better returns than passive funds just to stay even with them.

    The only thing hedge funds manage well is to lose money for their investors.

  • Report this Comment On January 31, 2014, at 3:16 PM, 092326 wrote:

    I think that you have made a very valid point. Hedge Funds are for the affluent, adventuresome investor and not the average investor who is attempting to build a fund for retirement.

  • Report this Comment On January 31, 2014, at 6:09 PM, whyaduck1128 wrote:


    There's one other thing that hedge funds manage well--accumulating the money to support the lifestyle the hedge fund managers want to live.

  • Report this Comment On February 03, 2014, at 2:44 PM, pax9677 wrote:

    Is there a specific Vanguard 69/40 index fund? I cannot find the symbol, and I am very interested in it.

  • Report this Comment On February 16, 2014, at 3:14 PM, jaybird43 wrote:

    Yes, the fund is vanguard BALANCED INDEX. I wonder though if a Vanguard fund(Wellesley) which has basically a 40/60 split didn't do even better?

  • Report this Comment On February 22, 2014, at 8:13 AM, clbjblk wrote:

    I am buy in and selling puts in this company and the last 6 moths doing well. the stock sells between 5 $ to 6 $ SOME TIMES A LITTLE LOWER OR HIGHER. But the only thing got me staying with them is it caught my eye that about 70% of the company is owned by Institutions and a lot of them. Also they are many big name Institutions 70 % owned by the Institutions , you know any others like that and is it a common statistic? Just closed another option today but just got to keep premium , and that's how I buy it just mostly selling put options and it is about a 50/50 . Any idea what is the norm for institutions , several like 20 institutions in this company. Just a thought there might be others, or the reason is it common. The company is in North America and there volume is

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Economics and finance columnist for Analyst, Motley Fool One.

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