The World's Smartest Investors Have Failed

The poor performance of hedge funds.

Jan 27, 2014 at 9:33AM

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." 

Contact Morgan Housel at The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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