The HFRX Global Hedge Fund Index underperformed all but two (U.S. REITs and Emerging Markets) of the major equity asset classes. An all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned 24.2 percent. Also, a 60 percent equity/40 percent bond portfolio with those weights for the equity allocation would have returned 14.6 percent using one-year Treasurys, 14.1 percent using five-year Treasurys and 10.0 percent using long-term Treasurys.
Given the freedom to move across asset classes that hedge funds tout as their big advantage, one would think "advantage" would show up.
Over the long term, the evidence is even worse. For the 10-year period from 2004-2013, the HFRX Index returned 1.0 percent per year, underperforming every single equity and bond asset class. The table below shows the returns of the various indexes:
Annualized Returns 2004-2013
|Domestic Indexes||Return (%)|
|MSCI US Small Cap 1750 (gross dividends)||10.4|
|MSCI US Prime Market Value (gross dividends)||7.4|
|MSCI US Small Cap Value (gross dividends)||9.4|
|Dow Jones Select REIT||8.2|
|MSCI EAFE (net dividends)||6.9|
|MSCI EAFE Small Cap (net dividends)||9.5|
|MSCI EAFE Small Value (net dividends)||10.1|
|MSCI EAFE Value (net dividends)||6.8|
|MSCI Emerging Markets (net dividends)||11.2|
|Merrill Lynch One-Year Treasury Note||2.1|
|Five-Year Treasury Notes||4.3|
|20-Year Treasury Bonds||6.1|
Perhaps even more shocking is that over this period, the only year that the HFRX index outperformed the S&P 500 was 2008. Even worse, compared with a balanced portfolio of 60 percent S&P 500 Index/40 percent Barclay's Government/Credit Bond Index, it underperformed every single year.
For the 10-year period, an all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned 9.2 percent per year. And a 60 percent equity/40 percent bond portfolio with those weights for the equity allocation would have returned 7.1 percent per year using one-year Treasurys, 8.2 percent per year using five-year Treasurys, and 9.4 percent per year using long-term Treasurys.
The poor performance of the industry raises the question, Why is so much capital invested in hedge funds? One explanation is that it's the triumph of hope, hype and marketing over wisdom and experience.
I also believe that the behavioral explanation of the desire to be a member of a special club explains the large amount of capital investment in hedge funds. Meir Statman, a leader in the field of behavioral finance, explains: "Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds… We may not admit it, and we many not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and software that promises to tell us where the stock market is headed."
Statman goes on to explain that some invest in hedge funds for the same reasons they buy a Rolex or carry a Gucci bag with an oversized logo—they are expressions of status, being available only to the wealthy.
He also explains that hedge funds offer what he called the expressive benefits of status and sophistication, and the emotional benefits of pride and respect. He cites the cases of investors who complain when hedge funds lower their minimums.
Those expressive benefits explain both why Bernard Madoff was so successful and why high net worth individuals continue to invest in hedge funds despite their lousy performance—they are ego-driven investments, with demand fueled by the desire to be a "member of the club."
With that in mind, investors in hedge funds would be well served to consider the following from another leader in the field of human behavior, Groucho Marx: "I don't care to belong to any club that will have me as a member."
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.