Hedge Funds' Rotten Record

Last Updated Apr 4, 2009 4:17 PM EDT

Hedge funds were initially sold on the promise of superior performance. After years of poor performance, the new hook for investing in hedge funds is that they're really quite diversified. But that story doesn't hold up either.

As the table below demonstrates, the HRFX Index of hedge funds underperformed every major equity asset class as well as all high-quality fixed income indexes over the past six years. And this data includes 2008, the second worst year ever for stocks on a nominal year basis and their worst year ever on a real return basis. If you wanted to hedge the risks of stocks, the data makes clear that you'd be far better off simply adding an appropriate amount of high quality fixed-income assets.

2003-08

HFRX Index

â€"0.7%

Domestic Indexes

S&P 500

2.4%

Microcaps

5.4%

Large-Cap Value

4.9%

Small-Cap Value

8.6%

Wilshire REIT

5.9%

International Indexes

MSCI EAFE

7.5%

MSCI International Small

9.8%

MSCI International Value

8.6%

MSCI Emerging Markets

14.9%

Fixed Income

1-Year Treasury Notes

3.3%

5-Year Treasury Notes

5.3%

20-Year Treasury Bonds

8.8%

Hedge fund investing appeals to investors because of the exclusive nature of the club. The successful ones make for great cocktail party stories. Unfortunately, these fund managers demonstrate no greater ability to deliver above-market returns than active mutual fund managers. While investors in hedge funds were earning below-market returns, they were also (in many cases) assuming far more risk -- although they were probably unaware they were doing so. The following is a list of some of those risks:
  • Hedge funds lack the daily liquidity of mutual funds.
  • Hedge funds lack transparency -- a requirement for prudent decision-making. Investors in hedge funds lose control over their asset allocation, as they don't know the makeup of their hedge funds.
  • Hedge funds tend to invest in highly risky assets and assume large amounts of leverage.
  • Hedge funds tend to be highly tax inefficient.
  • Hedge funds don't combine well with equities -- the correlation of hedge funds to equities has a nasty tendency to turn high just when the diversification benefits are needed most.
  • Since there is no evidence of persistent performance beyond the randomly expected, there is no way to identify the few hedge-fund winners ahead of time.
Yes, a few hedge managers will succeed. However, the real tests are: Do more succeed than is randomly expected? Is there persistence in performance? As the historical record demonstrates that the answers to these questions are an emphatic no, you should logically avoid investing in hedge funds.

In my next post, we'll discuss a study that sheds some light on investors' experiences with hedge funds, which have been a little lagging.
  • Larry Swedroe On Twitter»

    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 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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