Swedroe: Lessons Of 2017, Part 3

Every year, the markets offer lessons on the prudent investment strategy. So far, we’ve covered what they taught us last year in lessons one through three and four through seven. Today, we’ll finish off 2017’s list with lessons eight through 10.

Lesson 8: Hedge funds are not investment vehicles, they are compensation schemes.

This one has been appearing as regularly as the lesson that active management is a loser’s game. Hedge funds entered 2017 coming off their eighth-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins. And investors noticed.

In 2016, poor performance and withdrawals led to the closing of 1,057 hedge funds, the most since 2008. However, even after withdrawals of about $70 billion, that still left about 9,900 hedge funds (729 new hedge funds were started) managing just more than $3 trillion as we entered last year.

Unfortunately, the losing streak for hedge funds continued into a ninth year as the HFRX Global Hedge Fund Index returned just 6.0% in 2017, underperforming the S&P 500 Index by 15.8 percentage points. The following table shows the returns for various equity and fixed-income indexes.

As you can see, the HFRX Global Hedge Fund Index underperformed the S&P 500 and nine of the 10 major equity asset classes, but managed to outperform two of the three bond indexes.

An all-equity portfolio allocated 50% internationally and 50% domestically, equally weighted among the indexes within those broader categories, would have returned 21.3%, outperforming the hedge fund index by 15.3 percentage points. A 60% equity/40% bond portfolio with the same weighting methodology for the equity allocation would have returned 13.0% using one-year Treasuries, 13.4% using five-year Treasuries and 15.3% using long-term Treasuries.

Each of the three would have outperformed the hedge fund index. Given that hedge funds tout the freedom to move across asset classes as their big advantage, one would think that “advantage” 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.

Over the long term, the evidence is even worse. For the 10-year period 2008 through 2017, the HFRX Global Hedge Fund Index returned -0.4% a year, underperforming every single equity and bond asset class. As you can see in the following table, underperformance ranged from 1.3 percentage points when compared to the Merrill Lynch One-Year Treasury Note Index to as much as 10.0 percentage points when compared to U.S small-cap stocks.

One Year Of Outperformance
Perhaps even more shocking is that, over this period, the only year the hedge fund index outperformed the S&P 500 was in 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.

For the 10-year period, an all-equity portfolio allocated 50% internationally and 50% domestically, equally weighted within those broader categories, would have returned 6.2% per year. A 60% equity/40% bond portfolio, again with the same weighting methodology for the equity allocation, would have returned 4.8% per year using one-year Treasuries, 5.9% per year using five-year Treasuries and 7.6% per year using long-term Treasuries. All three dramatically outperformed the hedge fund index.

Finally, you may recall that a decade ago, in 2007, Warren Buffett bet $1 million that an index fund would outperform a collection of hedge funds over 10 years. He has now won that bet, with the big winner being a charity called Girls Inc. Over the course of the bet, his S&P 500 Index fund returned 7.1% per year versus just 2.2% per year for the basket of hedge funds selected by an asset manager at Protégé Partners.

The bottom line is that the evidence suggests investors are best served to think of hedge funds as compensation schemes, not investment vehicles.

Lesson 9: Don’t let your political views influence your investment decisions.

One of my more important roles as director of research at Buckingham Strategic Wealth and The BAM Alliance involves working to help prevent investors from committing what I refer to as portfolio suicide—panicked selling resulting from fear, whatever the source of that fear may be. The lesson to ignore your political views when making investment decisions is one that rears its head after every presidential election, and this time was no different. It seems to have become much more of an issue in 2017 because of the divisive views held by many about President Trump.

We often make mistakes because we are unaware that our decisions are being influenced by our beliefs and biases. The first step to eliminating, or at least minimizing, such mistakes is to become aware of how our choices are impacted by our views, and how those views can influence outcomes.

The 2012 study “Political Climate, Optimism, and Investment Decisions” showed that people’s optimism toward the financial markets and the economy is dynamically influenced by their political affiliation and the existing political climate. Among the authors’ findings were:

• Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their preferred party is in power. This leads them to take on more risk, overweighting riskier stocks. They also trade less frequently. That’s a good thing, as the evidence demonstrates that the more individuals trade, the worse they tend to do.
• When the opposite party is in power, individuals’ perceived uncertainty levels increase and investors exhibit stronger behavioral biases, leading to poor investment decisions.

Now, imagine the nervous investor who sold equities based on views about a Trump presidency. While investors who stayed disciplined have benefited from the rally, those who panicked and sold not only have missed the bull market, but now face the incredibly difficult task of figuring out when it will be once again safe to invest.

Similarly, I know of many investors with Republican leanings who were underinvested once President Obama was elected. And now it’s Democrats who have to face their fears. The December 2016 Spectrem Affluent Investor and Millionaire Confidence surveys provided evidence of how political biases can impact investment decisions.

Prior to the 2016 election, with a victory for Hillary Clinton expected, those identified as Democrats showed higher confidence than those who identified as Republicans or Independents. This completely flipped after the election. Those identified as Democrats registered a confidence reading of -10, while Republicans and Independents showed confidence readings of +9 and +15, respectively.

What’s important to understand is that if you lose confidence and sell, there’s never a green flag that will tell you when it’s safe to get back in. Thus, the strategy most likely to allow you to achieve your goals is to have a plan that anticipates there will be problems, and to not take more risk than you have the ability, willingness and need to assume. Additionally, don’t pay attention to the news if doing so will cause your political beliefs to influence your investment decisions.

Lesson 10: Just because something hasn’t happened doesn’t mean it won’t.

As we entered 2017, with U.S. stock valuations at historically very high levels, many investors were waiting for a market decline before they would buy equities again. Giving them confidence there would be a bear market (a drop of 20% or more), a “correction” (a drop of 10% or more) or at least a dip was that the S&P 500 had never gone a full year in which there wasn’t at least one month with a negative return. The only year that came close was 1995, which saw a drop of just 0.4% in October.

As it turned out, 2017 set a record, with every month showing a gain, extending the index’s record-setting winning streak to 14 months. This provides a good example of why I consider it a rule of prudent investing to never treat the unlikely as impossible or the likely as certain. In case you’re interested, or are one of those investors waiting for that dip, 1995 was followed by another strong year, with the S&P 500 up 23%.

Investors would do well to remember this advice from Peter Lynch: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”

Summary

2018 will surely offer investors more lessons, many of which will be remedial courses. And the market will provide you with opportunities to make investment mistakes. You can avoid making errors by knowing your financial history and having a well-thought-out plan. Reading my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” will help prepare you with the wisdom you need.

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