Can Hedge Fund Returns Stage A Comeback?

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By their very name, you know that a hedge fund has the capability to provide a portfolio with valuable fortifications against difficult financial markets and government currency decisions.  Yet while hedge funds have been promoted as a cure-all by investment advisors for less-than-optimal market returns, especially since hedge fund managers charge a two percent return in addition to a twenty percent performance royalty, their actual performance has hardly been worth the trouble.  The five-year rolling average of hedge fund returns has collapsed worse than just about any investment imaginable since 1995, where they peaked at a twenty-percent return and today are lucky to hit even five percent.  That makes hedge funds barely any better than a money market account or a certificate of deposit, which themselves are only a small step up from a savings account.  Have we seen the decline and fall of the hedge fund empire, or should investors hold out for a comeback?

Challenges To The Throne

Nothing has undermined the confidence of hedge fund investments quite like exchange traded funds.  ETFs have become one of the most popular options for playing the market: in 1999, they accounted for just ten percent of the total value of all hedge funds traded on the market, while today both hedge funds and ETFs have equal amounts of money under management at just under three trillion dollars in total.  Why have ETFs become the most popular kid at the table?  For one, the versatility of trading for the price difference between an asset and its underlying security make hedge funds look like lumbering dinosaurs.  Should an investor want to trade for Singapore currency exchange traded funds at two in the morning, they can do so and then turn their attention to speculative markets and finish up with penny stocks.  The tight rules applied to hedge funds by their fund managers make it difficult, if not impossible, to micro-manage an account.  Since ETFs trade off of a benchmark such as the S+P 500, it's possible to quite literally trade on a dime, buying and selling from the base at any second's notice in order to capitalize on even a fraction of a percentage of over- or under-valuation.  What's more, ETFs are laughably inexpensive in comparison to the Ferrari-esque hedge fund premiums, charging as little as one tenth of one percent per year.  For those who love to play with their money and love to pay a pittance for the opportunity, ETFs offer everything that hedge funds fail to deliver up.  Yet they alone aren't responsible for sinking the SS Hedge Fund.

But What Have You Done For Me Lately

The definition of insanity, said Albert Einstein, is doing one thing again and again and expecting different results.  With that quote in mind, it's hard to think that the genius who figured out E=MC2 would invest his own money in hedge funds that have been doing the same thing again and again while getting poor results.  While the hedge fund industry prides itself on making profits while underlying markets experience turbulence, the 2008 recession (that great leveler of claims) saw hedge funds take a fantastic hit, with a five-year rolling average that dropped from above ten percent to below five percent -- the current valuation that they have remained stuck on in the half-decade since the global financial crisis.  In fact, since 2008 the returns on hedge funds haven't done any better than bonds, despite the fact that the bond market is currently one of the worst in all of economic history as well as the fact that bonds trade on far lower fees than hedge funds.  Hedge fund managers may flatter themselves that they as an individual can outperform the market average, especially those with the skill and acumen to get better returns from equities and bonds than the current market offers, yet this provides little benefit to the average investor, who has little way to find the elite amongst the sea of average.  If it were easy to do, after all, there would be no average hedge fund managers and only the very best would be in business.

Long-Term Care

One of the largest problems for an individual investor is whether or not they have money in a hedge fund that they cannot alter.  Pension plans, for instance, tend to love putting money in hedge funds thanks to the all-too-close connection between money managers and mass-investment entities.  Pension developers bought the hedge fund pitch of lower volatility and diversification hook, line, and sinker.  Some ten percent of all pension fund money in the entire world is socked away in hedge funds that are lucky to earn even two percent growth per year.  Combine that with ample opportunity for fraud and it's clear why the hedge fund sits in drastic risk of decline; CalPERS, one of the largest US pension systems, announced that they would pull all their liquidity from hedge funds and recommended that other pension plans do the same.  When Treasury bonds yield two percent per year, why bother balancing risk and reward?

It's Your Money -- Or At Least It Should Be

  • Investment advisors are increasingly recommending that portfolios contain fewer and fewer hedge funds.  If your holdings are more than ten percent invested in hedge funds, whether through an individual IRA or a mass pension plan, remove as much of your stake as possible.  The return on investment simply isn't worth the bother.
  • Investors with time on their hands should consider ETFs a practical alternative to money management.  ETFs are excellent educational tools for the market, furthermore, since almost any security can be traded on an exchange-traded fund.
  • Almost any index fund will do better than almost any hedge fund.  The five-year rolling average of index funds beats out 80% of the competitors (bonds, T-bills, real estate securities, etc.) making them one of the best investment tools available.  A portfolio should have at least one-third of its total assets as index funds in order to capitalize on blanket market growth in a sector.
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