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.
