Hedge funds began this year coming off their seventh-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins. What’s more, for the 10-year period ending 2015 (one that included the worst bear market in the post-Depression era), the HFRX Global Hedge Fund Index managed to return just 0.1% a year, underperforming every single major equity and bond asset class.
Unfortunately for hedge fund investors, so far 2016 has not been kind. The bottom line for hedge funds is that their negative performance streak has continued into an eighth year. The HFRX Global Hedge Fund Index gained just 1.1% through September, underperforming nine of the 10 major equity asset class indexes as well as five-year Treasury notes and 20-year Treasury bonds.
The following table shows the returns for various equity and fixed-income indexes through the first nine months of 2016.
As you can see, the hedge fund index underperformed nine of the 10 major equity asset classes (just barely outperforming the MSCI EAFE Value Index by 0.3 percentage points) and two of the three bond indexes (outperforming the virtually riskless one-year Treasury note by only 0.4 percentage points). We can, however, take our analysis a step further and determine how hedge funds performed against a globally diversified portfolio.
Hedge Funds Vs. Portfolios
An all-equity portfolio allocated 50% internationally and 50% domestically—equally weighted among the 10 indexes within those broad categories—would have returned 8.4%, outperforming the hedge fund index by 7.3 percentage points.
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 5.3% using one-year Treasurys, 6.8% using five-year Treasurys and 7.1% using long-term Treasurys. Each of the three portfolios would have far 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 it would have shown up. The problem is that the efficiency of the market, as well as the cost 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 2006 through 2015, the HFRX Global Hedge Fund Index shows a return just 0.1% a year and, as mentioned previously, underperformed every single equity and bond asset class. The table below shows the returns of the various indexes.
Hedge Funds Consistently Underperform
Perhaps even more shocking is that, over this period, the only year the hedge fund index outperformed the S&P 500 Index was 2008. Even worse, when compared to a balanced portfolio allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond Index, it underperformed every single year.
Again, we will look at the hedge fund index’s results compared to diversified portfolios. For the 10-year period, an all-equity portfolio allocated 50% internationally and 50% domestically—equally weighted among the 10 indexes within those broad categories—would have returned 7.4% per year. And a 60% equity and 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.
Hedge funds’ miserable performance over both the short and long term finally seems to be leading investors to reduce their exposure to them. Back in August, Bloomberg reported that investors had pulled an estimated $25.2 billion from hedge funds in July, at that time the biggest monthly redemption since February 2009. It was also the second-straight month of withdrawals for the beleaguered industry, which saw $23.5 billion pulled in June, bringing total outflows to $55.9 billion through the first seven months of this year.
State pension plans have been among those withdrawing assets from hedge funds due to poor performance. For example, in May, Phil Murphy, the former U.S. Ambassador to Germany, a former senior executive at Goldman Sachs, and chairman for the nonprofit New Way for New Jersey, wrote that over the past five years, the hedge fund investments of the New Jersey pension fund “generated returns that were nearly 60% below the S&P. This is a complete violation of the principle ‘you get what you pay for.’ The big winners were the hedge funds and private equity managers whom we handsomely paid.”
We’ll report back again at the end of the year.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.