What was the biggest surprise to hit the markets in 2014? I think most investors would tell you it was either that interest rates fell or that the price of a barrel of oil fell by half. My own view is that there was a far bigger one.
For the 12 months ended August 2014, equity index funds and ETFs attracted $131 billion in net cash inflows, while actively managed funds suffered outflows of $55 billion.
These figures shouldn’t shock anyone, given the consistently poor performance of actively managed funds.
The real surprise is that, even though the hedge fund performance makes the returns of actively managed mutual funds look absolutely stellar, investors continued to pour money into them. In 2014, the HFRX Global Hedge Fund Index returned -0.6 percent. And for the 10-year period ending 2014, it returned just 0.7 percent, underperforming not only every major equity asset class, but even virtually riskless one-year Treasury bills.
The Biggest Surprise Of All
This type of performance is the reason behind the famous aphorism that hedge funds aren’t investment vehicles, nor are they an asset class—they’re actually compensation schemes.
Despite the miserable performance of hedge funds, capital continued to flow into the industry. Through the first three quarters of 2014, hedge fund industry assets grew by $190 billion. It was the ninth-consecutive quarter that the industry set a new high in assets under management.
In the following three months, investors allocated $3.6 billion in new capital to hedge funds globally, bringing full-year 2014 inflows to $76.4 billion, the highest calendar year of inflows since 2007. The industry’s total assets under management are an estimated $2.85 trillion.
What I’m driving at is the that the fact that investors continue to ignore a decade of miserable performance and keep pouring assets into hedge funds qualifies to me as the biggest surprise of 2014.
Reputable Critics Quoted
Perhaps this disconnect is what led Nobel Prize winner Eugene Fama to provide this warning about investing in hedge funds: “If you want to invest in something [hedge funds] where they steal your money and don’t tell you what they’re doing, be my guest.” Rex Sinquefield, co-founder of Dimensional Fund Advisors, went much further, calling hedge funds “mutual funds for rich idiots.”
That may seem harsh, but even the term “hedge fund” is an oxymoron. With the exception of dedicated short funds, most hedge funds don’t hedge anything. What’s more, the returns of most hedge funds are highly correlated with both volatility and the equity markets, and also are well explained by exposures to common factors (such as beta, size, value, momentum, quality, low volatility, term risk and default risk).
John Cochrane, well-known finance professor at the University of Chicago, put it this way: “Hedge funds are not a new asset class … they trade in exactly the same securities you already own.”
IIn his book “Unconventional Success,” David Swensen, chief investment officer of the Yale Endowment, provided these cautionary words: “In the hedge fund world, superior active management constitutes a rare commodity. Assuming that active managers of hedge funds achieve success levels similar to active managers of traditional marketable securities, investors in hedge funds face dramatically higher levels of prospective failure due to the materially higher levels of fees.”
As for funds of hedge funds, Swensen called them “a cancer on the institutional-investor world” and said they “facilitate the flow of ignorant capital.”
Cliff Asness, one of the founders of AQR Capital, offered this perspective: “One definition of hedge funds may resonate with many investors: Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.”