Hedge Fund Update for Third Quarter 2011

Last Updated Oct 12, 2011 1:40 PM EDT

A truly amazing phenomenon is the continued popularity of hedge funds, especially among high-net-worth investors. Despite the historical evidence on their lousy performance (as presented in my book The Only Guide to Alternative Investments You'll Ever Need), hedge funds continue to attract great attention. Instead of hype and hope, we continue to provide investors with the data. The table below presents the returns of the HFRX Global Hedge Fund Index and compares it to the performance of various equity and fixed income indexes, both for the period from 2003 through 2010 and also for the first nine months of 2011. The evidence should speak for itself.

Over the full period, the hedge fund index not only has underperformed every single equity asset class, but it also has underperformed even virtually riskless one-year Treasury bills (while taking far more risk) and intermediate-term and longer-term Treasury indexes as well.

To be fair, we'll point out that the hedge fund index did outperform the S&P 500 Index and all the other major equity indexes except for U.S. REITs during the first nine months of this year. However, that isn't exactly a fair comparison as there are many hedge funds that aren't fully exposed to market risk (such as merger arbitrage funds, long/short funds, currency and commodity funds, credit arbitrage funds and so on). Thus, a more appropriate way perhaps to look at these funds is to consider at least comparing their returns to diversified portfolio (such as a 60 percent stock /40 percent bond portfolio, diversified across asset equity asset classes). With that in mind, you can compare any particular mix you think is appropriate. This same analysis should be considered when looking at the long-term evidence.

Given the evidence, the only logical explanations I can think of for the continued popularity of hedge funds are that investors are unaware of the data or invest in hedge funds for the same reasons they buy a Rolex or carry a Gucci bag -- they're expressions of status, prestige, exclusivity and sophistication. Letting emotions such as these determine investment decisions is a recipe for transferring assets from your wallet to the purveyors of such products.

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    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.