Hedge funds produced vanity, but no gains, in 2014

2015-01-22

Hedge fund manager John Paulson had one of his largest losses of the year on a gamble that big oil companies would gobble up smaller ones. Instead, some smaller energy stocks held by his firm, Paulson & Co., plunged in value amid weak crude-oil prices. 

Costly hedge funds available only to the super-rich and the well-connected produced worse investment performances last year than a simple, basic portfolio of index funds available to absolutely anybody.

Stop me if you’ve heard this one before.

The HFRX Global Hedge Fund Index of more than 7,500 funds around the world, tracked by Hedge Fund Research Inc., ended 2014 down 0.6%, while an alternative index tracked by eVestment, a rival, and constructed slightly differently ended the year ahead by 2.5%.

Meanwhile, the Barclays Aggregate U.S. Bond Index gained about 6.5%, and the S&P 500 stock index jumped nearly 14%.

You have to feel for the beautiful people, losing out like that even after their money manager got them into these great funds.

Well, actually, no you don’t.

There is no single perfect hedge fund index, as hedge funds cover a broad array of strategies, styles and investment classes around the world, from Asian bonds to U.S. stocks to commodity futures. The overall indices try to measure the universe of such funds in a reasonable and representative manner.

Naturally there have been successful hedge funds as well as flops, just as there have been super-successful stock and bond markets.

Last year’s dismal industry performance is not a first. Indeed, according to Hedge Fund Research, over the past five years the industry has produced aggregate net returns, after fees, of only 5.3%.

No, not 5.3% a year — 5.3% in total. (That is the compound return of the HFRX Global Hedge Fund Index returns for 2010 through 2014.)

That’s some performance.

Meanwhile, world stock markets, as measured by the MSCI All World Index, gained 50%.

OK, so hedge funds claim to offer diversification and lower volatility than stocks, and so the fairest benchmark should include bonds as well as stocks. But that doesn’t help their case.

Consider, for example, a super simple, plain-vanilla portfolio of just three funds: 60% Vanguard’s Global Equity Fund, 20% Long-Term U.S. Treasury fund, and 20% Inflation-Protected Securities Fund. Such a portfolio returned 8.4% last year, which is more than three times as much as the average hedge fund tracked by eVestment and, naturally, vastly better than the slight loss tracked by Hedge Fund Research.

And that portfolio of three Vanguard funds, rebalanced just once a year, has produced gains over the past five years of 58%, or more than 10 times the returns of the average hedge fund.

(This three-fund portfolio avoids almost any accusation of hindsight bias. The stock allocation is global, thereby including markets that did well, such as the U.S., and less so, such as much of Europe. The bond allocation is split evenly between long-term Treasuries, which act as protection against a crash or deflation, and inflation-protected bonds, which tend to be less volatile, but do offer a cushion against inflation shocks. It’s not the perfect all-weather portfolio — that’s a story for another day — but in a pinch, it will do pretty well.)

Hedge funds should not be understood as investment vehicles. They are luxury goods. The purpose of a hedge fund is to show off how rich and well-connected you are. Sure, they cost the Earth, but so does a Ferrari.

Then again, at least a Ferrari produces performance. Imagine blowing a fortune on a Ferrari that went slower than a bicycle.