The financial press is increasingly critical of an investment product it glamorized in the past ? hedge funds. As a group they have underperformed unmanaged stock and balanced fund indices for the last 10 years while enriching fund managers. Yet more hedge funds continue to come on line. The question is why do they continue to attract investors?
Hedge funds overall returned just 3% in 2012, as measured by the HFRX Indices, which are widely used benchmarks used to compare hedge fund performances, versus an 18% return for the S&P 500 stock index. The S&P 500 has outpaced most hedge funds for the last ten years. A balanced index fund consisting of 60% equities and 40% fixed income returned approximately 90% over the last ten years, while the average hedge fund returned just 17% for the same period after accounting for fees and expenses. To put it in context, hedge funds as a group returned less than inflation over the past decade (“Going nowhere fast,” The Economist, Dec. 22, 2012).
Such dismal results lend support to Warren Buffett’s characterization of hedge funds as little more than “manager compensation schemes.” The typical hedge fund charges a management fee of 2% off the top plus 20% of profits over a certain level. No wonder there are nearly 8,000 hedge funds and more coming on line.
Ironically, hedge funds are now trying to reposition their marketing to tout the supposed long-term stability of their returns. But that purported stability is often the result of illiquid private holdings that are valued at par even after bona fide analyses would produce lower valuations, and would indeed demonstrate that the true underlying volatility is just being masked.
Hedge funds used to be vehicle of choice for extremely wealthy speculators. Today, almost 67% of hedge fund investors are institutions like pension funds and college endowments. These institutions are by and large reputed to be more risk-averse than the average investor, and are said to demand greater transparency and diversification. Most hedge funds, however, are relatively opaque and non-diversified. Consequently, institutional investors (and retail investors) would be better off in a broadly diversified exchange traded fund or balanced index mutual fund.
Page Perry is an Atlanta-based law firm with over 150 years of collective experience maintaining integrity in the investment markets and protecting investor rights.