Don't be a member of the hedge fund club

2013 was another great year for the global hedge fund industry. Net inflows were almost $64 billion and total assets reaching $2.63 trillion. Unfortunately, investors in hedge funds haven't fared as well as the purveyors. Thus, we have one of the more puzzling anomalies in finance -- the continued growth of an industry that for a long time has delivered miserable results for investors. The first quarter of 2014 didn't off much of a reprieve.

The table below shows the return of the HFRX Global Hedge Index for the first quarter of 2014 as well as the 10-year period 2004-13. It also presents the returns of the major equity asset classes and 1-, 5-, and 20-year Treasuries. Over the prior 10 years the HFRX Global Hedge Fund Index underperformed every major equity asset class and even the three Treasury indices. And the 1.1 percent return of the index in the first quarter of 2014 certainly wasn't anything to boast of.
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Reviewing the data, it's hard to understand why assets keep flowing into the industry. Hedge funds underperformed each of the major domestic equity asset classes. They underperformed three of the five international asset classes. And while they outperformed 1-year Treasuries, they just matched the returns of 5-year Treasuries and underperformed 20-year Treasuries.

As is our practice, we'll also compare the return of the HFRX Index against the return of a 60 percent stock/40 percent bond portfolio, with the stock portion holding a 6 percent allocation to each of the 10 asset classes (providing a 30 percent allocation to both domestic and international stocks). A portfolio more heavily weighted to domestic stocks would have provided higher returns as U.S. stocks outperformed international stocks.

- 60% stock/40% 1-year Treasury: 1.7 percent

- 60% stock/40% 5-year Treasury: 2.2 percent

- 60% stock/40% 20-year Treasury: 4.3 percent

Despite their touted ability to move assets to where the best opportunities are, hedge funds underperformed all three of the globally diversified portfolios, while generally taking more risk.

Given their poor performance why do investors keep increasing their exposure to hedge funds? One explanation is that it's the triumph of hope over experience. However, Meir Statman, a leader in the field of behavioral finance, provides us with another explanation. He explains: "Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds... We may not admit it, and we many not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and software that promises to tell us where the stock market is headed." He goes on to explain that some invest in hedge funds for the same reasons they buy a Rolex or carry a Gucci bag with an oversized logo -- they are expressions of status, being available only to the wealthy.

Writing in 1973, John Brooks offered up this: "Exclusivity and secrecy were crucial to hedge funds from the first. It certifies ones affluence while attesting to one's astuteness."

Statman explains that hedge funds offer what he called the expressive benefits of status and sophistication, and the emotional benefits of pride and respect -- they're ego driven investments, with demand fueled by the desire to be a "member of the club." With that in mind, investors in hedge funds would be well served to consider the following from another leader in the field of human behavior, Groucho Marx: "I don't care to belong to any club that will have me as a member."


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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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