Swedroe: Hedge Funds Miss Mark

Hedge funds began 2015 coming off their sixth-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 2014, one that included the worst bear market in the post-Depression era, the HFRX Global Hedge Fund Index returned just 0.7% per year, underperforming every single major equity and bond asset class.

Unfortunately for hedge fund investors, that streak has continued into a seventh year, as the HFRX Global Hedge Fund Index lost 3.6% in 2015, underperforming the S&P 500 Index by 5.0 percentage points.

The following table shows the returns last year for various equity and fixed-income indexes:

As you can see, the HFRX hedge fund index underperformed six of the 10 major equity asset classes, as well as each of the three bond indexes. We can, however, go a step further and determine how hedge funds performed against a globally diversified portfolio.

An all-equity portfolio—allocated 50% internationally, 50% domestically and assigning an equal weighting of 10% to each of the 10 equity indexes referenced in the above tables—would have returned -1.2%, outperforming the hedge fund index by 2.4 percentage points.

Another comparison we can make is to a typical balanced portfolio of 60% equities/40% bonds. Using the same weighting methodology as above for the equity allocation, the portfolio would have returned -0.6% using one-year Treasurys, 0.0% using five-year Treasurys and -0.8% using long-term Treasurys. Each of the three would have outperformed the hedge fund index.

Given the freedom to move across asset classes that hedge funds often tout as their big advantage, one would think that would have shown up in the performance. The problem is that the efficiency of the market, as well as the costs of the effort, turns that supposed advantage into a handicap.

Furthermore, over the long term, the evidence is even worse. For the 10-year period from 2006 through 2015, the HFRX Global Hedge Fund Index managed to return just 0.1% per year and underperformed every single equity and bond asset class. The table below shows the returns of the various indexes:

Perhaps even more shocking is that over this period, the only year that the hedge fund index outperformed the S&P 500 was 2008. Even worse, when compared to a balanced portfolio allocated 60% to the S&P 500 Index and 40% to the Barclay’s Government/Credit Bond Index, it underperformed every single year.

Again, we’ll look at the results compared to diversified portfolios. For the 10-year period, an all-equity portfolio—allocated 50% internationally, 50% domestically and assigning an equal weighting of 10% to each of the 10 equity indexes referenced in the above tables—would have returned 7.4% per year.

A 60% equity/40% bond portfolio with those same weights for the equity allocation would have returned 5.9% per year using one-year Treasurys, 7.1% per year using five-year Treasurys and 8.9% per year using long-term Treasurys. All three dramatically outperformed the hedge fund index.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.