Swedroe: Mystery Of Hedge Fund Survival

While mutual fund investors are wising up, hedge fund investors aren’t.

The first quarter of this year brought hedge funds little in the way of relief from their historically poor performance. They entered 2015 coming off a sixth-straight year of trailing U.S. stocks by significant margins. And for the 10-year period from 2005 through 2014—which includes the worst bear market in the post-Great Depression era—the HFRX Global Hedge Fund Index returned just 0.7 percent per year, underperforming every single major equity and bond asset class.

Despite their poor performance over the past decade, the latest data shows that investors continue to pour money into hedge funds, which now have total assets under management of almost $3 trillion. What’s particularly puzzling is that we don’t see this same trend when we look at the fund flows for actively managed mutual funds.

In aggregate, actively managed funds persistently underperform, and investors are taking notice and acting. For example, Morningstar recently reported that over a one-year period through early December 2014, roughly $92 billion in assets departed actively managed U.S equity funds, while approximately $160 billion in new inflows went into passively managed U.S. equity products—both traditional index funds and exchange-traded funds (ETFs).

A Performance Comparison
Figure 1 shows the returns of the HFRX Global Hedge Fund Index for the first three months of 2015 as well as the 10-year period from 2005 through 2014. It also shows the returns of major equity asset classes and of one-, five- and 20-year Treasurys.

Figure 1: Hedge Fund Vs. Equity Index Performance

In the first three months of 2015, the HFRX Index returned 2.1 percent. Of the 10 major equity asset classes, it outperformed just two. As is our practice, we will compare that return to the performance of three standard 60 percent stock and 40 percent bond portfolios.

For their equity portion, each of the three portfolios we’ll consider equally weights the 10 stock indexes listed in the table above. That means each index represents 6 percent of the total portfolio. In addition, domestic and international stocks each represent 30 percent of the whole portfolio, or half the equity allocation. And for their fixed-income portion, our portfolios each use one of the three bond indexes below.

• Portfolio A uses one-year Treasury notes.
• Portfolio B uses five-year Treasury notes.
• Portfolio C uses 20-year Treasury bonds.

The results are in Figure 2.

Figure 2: Hedge Fund Vs. Portfolio Performance

As you can see, the HFRX Index managed to match the performance of Portfolio A, but underperformed both B and C.

A Thriving Mystery

Hedge funds continue to thrive, with their assets under management continuing to set new records. Unfortunately, the evidence makes it clear that investors in hedge funds haven’t fared as well as hedge fund vendors or managers.

That results in one of the more mystifying anomalies in finance—the continued growth of an industry that has delivered miserable results for investors. The only explanation I can offer is that it’s the triumph of hype, hope and marketing over wisdom and experience.

We’ll again check back on hedge fund performance at the end of the second quarter.

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