Hedge Funds: Why they don’t produce very good returns?

hedge funds

Hedge funds are a popular investment option for high net worth individuals and institutions. Hedge funds seek to produce both capital appreciation and income from a variety of asset classes with time horizons of 3-5 years or longer. However, according to a study by the University of Chicago’s Booth School of Business, many hedge fund managers do not achieve their goals because they tend to hold on to losing investments too long.

The Reality Of Hedge Funds

If you asked a random person on the street to choose between the S&P 500 and a professionally managed hedge fund, chances are most of them would choose the hedge fund. And this makes sense, I mean why would you invest into the broad market when you can have hundreds of financial professionals actively manage your money on a day to day basis.

Though the opportunity sounds awfully attractive, the average person doesn’t have access to a hedge fund. Most hedge funds not only require that you’re a millionaire but also that you invest $1 million into the hedge fund itself. These lofty requirements have given hedge funds an image of being a fancy investment tool for the filthy rich.

But, when we peel back the layers, we’ll see that hedge funds aren’t actually that fancy. In fact, an investment into the S&P 500 in 2010 would’ve produced nearly triple the returns of hedge funds. So, here’s the truth about hedge funds’ poor returns, and why the rich levitate towards hedge funds nonetheless.

Before we get into the various reasons hedge funds underperform the market, let’s first take a look at the proof. The following table showcases the average returns produced by hedge funds and the S&P 500 every year since 2011. As you can see, the hedge funds underperformed the S&P 500 every single year. On green years, they made less money and on red years, they lost more money.

If we do a bit of math, we’ll see that the average annual return for hedge funds is 4.956% while the average annual return for the S&P 500 is 14.4%. So, the S&P 500 crushed hedge funds over the past 10 years. Warren Buffett even predicted this outcome way back in 2008.

In 2008, Warren Buffett bet $1 million that the S&P 500 would outperform hedge funds over the next ten years. By 2015, hedge funds were losing so badly to the S&P 500 that Buffett’s opponent Ted Seides actually conceded 2.5 years early.

So, there’s no question that hedge funds have underperformed the market, but in reality, this is not that fair of a comparison because there’s so many more factors that go into running a hedge fund such as hedging.

Hedging

As the name suggests, hedge funds hedge their bets meaning that they always play the market to both sides. They could be 99% confident that Apple stock will be higher than it is today 10 years from now, but despite that, they’ll have to allocate a portion of their portfolio to betting against Apple.

Now, they don’t have to straight up short Apple stock or buy puts on Apple. But what they do have to do is somehow offset the risk they take on by purchasing Apple stock. And to do this, they use something called beta. Beta is a measure of a stock’s perceived volatility in comparison to the overall market.

The S&P 500 is the baseline, so stocks that perform identically to the S&P 500 have a beta value of 1. Stocks that outperform the market like Apple and Tesla have a beta value greater than 1. Meanwhile, stocks that underperform the market but are still positive have a beta value between 0 and 1. And finally, stocks or positions that are negative when the market goes up or vice versa have a negative beta value.

The standard in the hedge fund industry is to maintain an overall beta value of 0 which means that the fund is neutral to the market. Some hedge funds do strive for negative beta values or even beta values above 1. But in most cases, the goal is to maintain a low beta value. Considering this, most hedge funds are consistently burning large amounts of money maintaining low beta values which prevents them from benefiting from large moves in either direction.

Massive Fees

Aside from hedging, hedge funds burn a lot of money on fees. When it comes to passive index funds, the fund managers don’t really have to do much. Every quarter a couple of companies will get kicked out of the S&P 500 and a couple will be added.

So, index fund managers will have to go ahead and buy and sell some positions every quarter, but that’s pretty much it. As a result, passive funds have extremely small expense ratios. The Vanguard S&P 500 fund, for instance, has an expense ratio of only 0.03%.

This means that for every $100 you invest into the fund, only 3 cents goes to the fund managers on an annual basis. With hedge funds on the other hand, financial analysts and portfolio managers dedicate their entire lives to managing the fund.

On average, individuals working at hedge funds and investment banks work 80 to 100 hours every single week. And given their massive commitment, they expect to be well compensated. The standard fee structure at hedge funds follows the 2 and 20 rule.

This rule suggests that hedge funds will earn a management fee of 2% per year and 20% of all generated profits. If we have a hedge fund that produces an annual return of 10%, the hedge fund would take 4% off the top meaning that the actual investor would only earn 6%.

To make things worse for investors, the better the track history of a hedge fund, the higher their fees will be. On the flip side, these high fees are extremely lucrative for hedge fund managers. In 2020, for instance, the top paid hedge fund manager was Chase Coleman, and he earned a whopping $3 billion.

I think you can see how such a compensation would make a massive dent in investor’s returns. And that brings us into the next factor holding back hedge funds which is diversification.

Diversification

The S&P 500 is known as one of the most diverse investments available on the stock market as it combines the gains and losses of the top 500 publicly traded companies. But, at the end of the day, the S&P 500 only deals with one asset class which is stocks.

Hedge funds on the other hand are able to invest into anything and everything. They invest into real estate, land, derivatives, bonds, private companies, foreign currencies and much more.

While some of these investments such as derivatives and private companies could provide greater returns than the S&P 500, most of these alternative investments come nowhere close to the returns of the stock market.

Take 10 year treasury bonds, for instance. Currently, a 10 year treasury bond will only pay you 1.3% per year. Similarly, real estate only appreciates 3 to 5% per year.

So, when you have 10% in bonds, 10% in real estate, 10% cash, and so on and so forth, it’s extremely difficult to beat an index that’s 100% stocks. And that’s why it’s not really fair to compare the overall returns of hedge funds with the S&P 500.

True Returns Of Hedge Funds

If you wanted a true apples to apples comparison between the two, you would need to look at only the stock holdings of hedge funds and then disregard the money spent on hedging the portfolio.

This is a much more accurate representation of the returns hedge funds would provide if they tried to maximize returns. And, we don’t have to guess the returns of these guys as there’s plenty of hedge funds that specifically focus on maximizing returns. And as you would guess, with all of their expertise and insider knowledge, they crush the markets.

Chuck Akre, for instance, boasts an annualized return of 46.4% over the past 3 years. Philippe Laffont achieved an annualized return of 49.9% over the past 3 years. Basically everyone on this list boasts returns of 30, 40, 50% year after year after year.

But by far the best hedge fund in history is Renaissance Technologies’ Medallion fund. Since 1988, the Medallion fund has achieved an annual average return of 66%. Given their unbeatable returns, they charge eye popping fees of 27%, and after fees, investors only get 39%. But, that’s still way higher than the S&P 500.

If there are hundreds of hedge funds that destroy the S&P 500, why don’t billionaires and institutions spread their money across these high flying hedge funds? Well, the answer is simple, and it comes down to the fundamental purpose of hedge funds.

Purpose Of Hedge Funds

By nature, hedge funds aren’t designed to provide massive returns and the wealthy do not invest into hedge funds expecting high returns. Rather, the primary goal of hedge funds is capital preservation, and this is what attracts billionaires towards them.

Here’s the thing, billionaires already have plenty of risky investments as the only way to become a billionaire is to make outsized bets on an industry or company. 90 to 95% of the wealth of most billionaires is concentrated into one maybe two companies. And given that they’re a billionaire, their investment has clearly crushed the market over the past several years.

Take Amazon for instance. If you invested $500 into Amazon when they went public, you would have 324 shares of Amazon today or about $1.184 million. That translates to an annual rate of return of 38.23%. Considering this, the last thing Jeff Bezos would want to do is go ahead and put the 5% of his Amazon shares that he does liquidate into a return oriented investment.

If anything, he wants to reduce his exposure to the market and hedge funds are often the perfect way to accomplish this. You see, though hedge funds get obliterated by the market during bull markets, the same cannot be said about bear markets.

The truth is, the general market not only runs up exponentially but it also falls exponentially. After the dotcom bubble, the nasdaq crashed 78% from its peak and individual tech companies like Amazon crashed even further. So, if you were a tech company owner in 2002, how were you going to live when all of your money is tied up into Amazon or Google.

You definitely don’t want to sell your shares at the bottom of the market after the stock just crashed 95%. In such a scenario, it would be really nice to have an investment that more or less held it’s value and you could withdraw from. And this is where hedge funds come into play.

Hedge Funds vs Index Funds

Hedge funds don’t rise as much as the market during bull markets, but they also don’t fall as much as the market during bear markets. This graph comparing hedge fund and S&P 500 performance since 1995 perfectly outlines this key difference.

As you can see, between 1995 and 2000 during the dotcom bubble, the S&P 500 doubled the returns of hedge funds. During the dotcom crash, the hedge funds basically went sideways while the market got crushed and by 2002, hedge funds took the lead.

In the 2008 financial crisis, hedge funds did take a hit, but the drop is only about half as much as the drop experienced by the markets. And the market didn’t overtake hedge funds till 2013 or 11 years after they lost the lead. The S&P 500 has dominated over the past decade, but it’s likely that during the next bear market, we’ll see hedge funds shine once again.

This doesn’t mean that index funds are better than hedge funds or that hedge funds are better than index funds. The reality is that they’re completely different tools that serve completely different purposes.

Index funds are perfect for capitalizing on strong bull markets while hedge funds are perfect for generating extremely consistent returns decade after decade. At the end of the day, hedge funds are quite complex and intricate, but not in the way you think.

They’re not some secret tool that the rich use to make billions. In fact, they’re more of a wealth preservation tool. And unless you have tens of millions in the market, you really have no need to be hedging with hedge funds.

Did you guys realize that hedge funds aren’t actually as fancy as they sound? Comment that down below.

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