Swedroe: Hedge Funds Flop. Again.

This article is the fourth of a four-part series containing 12 lessons that prudent investors could learn from the markets in 2014. The first, second and third articles appeared here, here and here.

Today marks the final installment in my series addressing the lessons that the markets taught us last year about prudent investment strategies. As we noted previously, 2014 provided us with a total of 12.

You may have observed by now that many of these same lessons show up year after year. And many times, the markets provide remedial courses on previously taught lessons. It seems, however, that investors keep failing to learn from them and continue making the same errors. But as I’ve said before, there’s nothing new in investing, only investment history you don’t yet know.

Lesson 10: Hedge Funds Are Not Investment Vehicles, They Are Compensation Schemes

This lesson holds the title with the most repeat performances. After all, the HRFX Global Hedge Fund Index earned -0.06 percent last year. The table below shows the returns for various equity and fixed-income indexes. 

An all-equity portfolio allocated 50 percent to international stocks and 50 percent to domestic stocks, equally weighted within these broad categories, would have returned 4.9 percent last year. And a 60 percent equity and 40 percent bond portfolio, with the same weights for the equity allocation, would have returned 3.0 percent in 2014 using one-year Treasurys. Alternatively, that portfolio would have returned 4.2 percent using five-year Treasurys and 12.5 percent using long-term Treasurys.

Hedge funds tout their freedom to move across asset classes as one of their big advantages. One would think that “advantage” would actually show up. The problem is that the efficiency of the market, as well as the costs of the effort, turn that supposed advantage into a handicap.

Over the long term, the evidence is even worse. For the 10-year period from 2005-2014, the HFRX Global Hedge Fund Index returned just 0.7 percent per year, underperforming 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 HFRX Global Hedge Fund Index managed to outperform the S&P 500 was in 2008. Even worse, when compared with a balanced portfolio allocated 60 percent to the S&P 500 Index and 40 percent to the Barclay’s Government/Credit Bond Index, HFRX underperformed every single year.

For the 10-year period, an all-equity portfolio allocated 50 percent to international stocks and 50 percent to domestic stocks, equally weighted within these broad categories, would have returned 7.4 percent per year. And a 60 percent equity and 40 percent bond portfolio, again with the same weights for the equity allocation, would have returned 5.9 percent per year using one-year Treasurys. And alternatively, that portfolio would have returned 7.1 percent per year using five-year Treasurys and 8.9 percent per year using long-term Treasurys.

Lesson 11: The Markets Will Test Your Discipline

On Sept. 19, 2014, the S&P 500 hit a high at 2,019. Less than four weeks later, on Oct. 15, it had fallen to 1,821, a drop of 9.8 percent. Such large and sudden swings in the markets test the discipline of investors, often leading their stomachs to take over the decision-making from their heads. And I’ve yet to meet a stomach that makes good decisions.

Bear markets can cause even well-thought-out plans to end up in the “trash heap of emotions.” Thus, it’s critical that investors don’t make the mistake of assuming more risk than they have the ability, willingness or need to take. Investors should also make sure to avoid the all-too-human mistake of succumbing to overconfidence. In this case, it’s overconfidence in your ability to stand the stress that comes with bear markets.

If the market did teach you a lesson in 2014—and even if you didn’t panic and sell, but found you weren’t able to sleep well or enjoy life—the best time to consider an allocation change is when things are going well and when your stomach isn’t driving decisions.

So if you were tempted to get more conservative when the market dipped, ask yourself if you have the most appropriate allocation for your peace of mind. Remember, the next market drop could always look a lot more like the one we experienced in 2008.

Lesson 12: Events Occur That No One Predicted

Those who have spent their careers forecasting—financial or otherwise—learn to be very humble about their predictions. The reason is that almost every year, major events occur that are total surprises. And by definition, surprises are unpredictable.

That is why when I’m asked for a forecast, my response is that my crystal ball is always cloudy. And that is why my recommendation to investors is always to stop spending time listening to and worrying about forecasts. Instead, spend it on managing risk.

There were two big surprises in 2014 that really stand out, because—to my knowledge—no one predicted either one.

The first is that, while almost everyone was warning investors to avoid long-term bonds, Vanguard’s Long-Term Treasury Fund (VUSTX) returned 25.7 percent. The other is the collapse in oil prices. The price of oil per barrel was cut roughly in half, from about $100 to about $50. Such events have a major impact on returns, yet they are unpredictable.

This year will surely provide investors with even more lessons, many of which will again be remedial courses. And the market will provide you with opportunities to make investment mistakes. You can avoid making mistakes by knowing your financial history and having a well-thought-out plan.

Try reading “Investment Mistakes Even Smart Investors Make.” It will provide you with the wisdom you need to avoid making them.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.