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Hedge funds lag the simplest portfolios

Racy hedge funds are lagging boring ETF portfolios

I have often written about my skepticism over hedge funds, absolute return funds, and other sexy investment vehicles.

Some of the problems with these exotic funds include:

  • They’re expensive – typically taking 2% annual charges and a 20% cut of returns.
  • They can be illiquid, locking away your money for years.
  • Many fail to deliver the absolute returns they promise.
  • You may not understand what you’re investing in, or the risks. (Think Madoff!)

Now we can add a new drawback – poor performance versus ETFs.

It turns out most hedge funds are currently doing worse than the simplest tracker-and-bond portfolio!

Hedge funds hammered

Despite devoting acres of coverage to hedge funds over the years, The Financial Times has finally noticed that the Emperor may have no clothes:

Hedge funds, the most expensive item on the investment menu, have been producing returns almost identical to portfolios from the cheap burger joints of the advisory business, made up of 60 per cent equities and 40 per cent bonds.

No wonder hedge funds are worried. Bankers report increasing concern among these latter-day masters of the universe over how they will pay the fat bonuses their traders demand.

As the FT’s graph shows (right), the index of hedge fund returns versus the simple portfolio has done especially badly in the past couple of years.

Up until then it was merely tracking the performance of a cheap 0.5% a year ETF portfolio!

Do you feel lucky, punk?

Whenever I write about exotic funds, somebody will come along and tell me I haven’t considered this or that pet strategy of theirs.

Indeed, a hedge fund fan would argue that the FT piece is flawed since it is comparing a simple portfolio with a basket of hedge funds.

This basket will contain absolute return funds, directional funds, macro funds, corporate activists, and all kinds of other strategies. Each would be expected to do better at different times in the economic cycle.

To which I’d say fair enough, but I’d add that the average investor – including me – is extremely unlikely to be able to judge what strategy is best at any given moment, or to move their money around in time.

As a result, he or she will either:

  • Hold the wrong hedge funds some of the time (getting average performance at high cost over the full cycle).
  • Or else will have to diversify into several funds (and so again get average performance at high cost over the full cycle).

Keep it simple, silly

If you’re an Ivy League endowment manager like David Swensen with massive resources at your disposal and funds beating down your door to get a chunk of your millions, you may just be able to pick the winners.

Some people will be lucky, too. Sod’s Law says you’ll likely meet one of them in a pub, who’ll tell you he’s made his fortune backing the one in a hundred fund that delivered 10,000% returns.

But you can’t invest based on luck, and I think the average investor will lose money in their doomed search for Perfect 10 investments.

A simple ETF portfolio – or even just a mix of trackers and cash – is easier to understand, far cheaper to run, and will likely deliver similar long-term returns to these pricier vehicles.

If you must have some excitement, trade a few shares in a side portfolio with a small proportion of your wealth, and be your own hedge fund manager.

You probably won’t beat the market, but at least you won’t be helping someone to buy a Ferrari with your hard-earned cash, either!

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{ 5 comments… add one }
  • 1 RetirementInvestingToday September 3, 2010, 1:26 pm

    Hi TI

    I own no hedge funds nor total return funds. In the good times IMO they ‘rip you off’ with their 20% performance fees on top of the large 2% or so management charge. In the bad times they don’t give any of those ‘performance fees’ back and you get to feel all the pain yourself while they still take their 2%. They really would need some serious out performance well above the average market return just to match trackers.

    I never could see how they would be beneficial long term and your post seems to confirm this. In the long term I can’t see how the average of all the hedge funds will do any better than average the market. Particularly as the number of them increases which will create more mediocrity. The only way I can see it happening would be to take more risk through leverage or equivalent but that doesn’t count as anybody can take more risk. It’s all about balancing risk versus return after all.

    It’s low fee stuff for me all the way allowing the saved fees to compound nicely. Minimise taxes for the same effect. Have a strategic asset allocation to fit your risk profile and rebalance appropriately. Finally to try and squeeze some performance use some tactical allocation based on current market valuations to shift allocations slightly. Boring I know but it seems to be working.

    .-= RetirementInvestingToday on: The low fee mantra – a look at the results of Hargreaves Lansdown =-.

  • 2 Niklas Smith September 3, 2010, 3:15 pm

    Brilliant! A very interesting read, though I suppose if you think about it not that surprising. It does rather torpedo the reasoning behind hedge funds (being insulated from swings in individual markets).

  • 3 Andrew September 4, 2010, 6:10 am

    I’ve also had similar skepticism over actively managed portfolios. While I think there are some that work, I think no portfolio can truly work year in and year out. I think the best actively managed portfolios are ones that are diverse and can adapt their strategies. With that said, I’m not sure it’s worth the high management fees. I think a larger majority of one’s portfolio should be put into an index fund or industry-focused fund with low fees but still a strong upside.

  • 4 ermine September 4, 2010, 10:39 am

    It seems to be the old black swan problem. Ever since LTCM they seem to be able to design more and more byzantine complexity to end-run all the known so far wrinkles. But there are always unknown unknowns that kill them in the end.

    Perhaps it is like Heisenberg’s Uncertainly principle. Maybe the very presence of hedge funds and the background radiation of the results of their action in the market generates the conditions to kill the golden goose. And so it will be for the next hypercomplex wheeze…
    .-= ermine on: Digital Taylorism – Why our Jobs are Getting Worse =-.

  • 5 The Investor September 4, 2010, 1:11 pm

    Yep, hedge funds chasing each others’ tales / strategies is a definite reason for reduced out-performance by all accounts. Economic theory says any repeatable method to make money in the markets should eventually be arbitraged away.

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