Hedge funds entered last year coming off their eighth-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins. And for the 10-year period ending 2017, one that included the worst bear market in the post-Depression era, the HFRX Global Hedge Fund Index produced a negative return (-0.4%), underperforming every single major equity and bond asset class.
Unfortunately, the losing streak for hedge funds continued into a ninth year, as the HFRX Global Hedge Fund Index returned just 6.0% in 2017, underperforming the S&P 500 Index by 15.8 percentage points. The following table shows the returns last year for various equity and fixed-income indexes.
As you can see, the hedge fund index underperformed nine of the 10 major equity asset classes but outperformed two of the three bond indexes. We can, however, take our analysis a step further and determine how hedge funds performed against a globally diversified portfolio.
An all-equity portfolio allocated 50% internationally and 50% domestically, equally weighted among the indexes within those broader categories, would have returned 21.3%, outperforming the hedge fund index by 15.3 percentage points.
Compared To A Balanced Portfolio
Another comparison we can make is to a typical balanced portfolio of 60% equities and 40% bonds. Using the same weighting methodology as above for the equity allocation, the portfolio would have returned 13.0% using one-year Treasuries, 13.4% using five-year Treasuries and 15.3% using long-term Treasuries. Each of the three would have outperformed the hedge fund index.
One may think hedge funds would have used their freedom to move across asset classes, which they often tout as their big advantage, to better effect. The problem is that the efficiency of the market, as well as the cost of the effort, turns that supposed advantage into a handicap. Given the evidence, it’s a puzzle why hedge funds are still managing about $3 trillion in assets.
Finally, you may recall that a decade ago, in 2007, Warren Buffett bet $1 million that an index fund would outperform a collection of hedge funds over 10 years. He’s now won that bet, with the big winner being a charity called Girls Inc.
Over the course of the bet, his S&P 500 index fund returned 7.1% a year versus just 2.2% a year for the basket of hedge funds selected by an asset manager at Protégé Partners. That 2.2% return actually was better than the return of the HFRX Global Hedge Fund Index over the period, which, as I noted, was -0.4%.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.