Hedge Funds Have a Bad Year, Again.

Coming out of the tech crash in the early 2000s, investors everywhere were looking for a new edge. One of the trends that came out of the next decade was an increased interest in a little known structure that had been used sparingly since the 1920s, the hedge fund.

Most of you are scratching your heads. “Hedge fund”, I have heard of those, but nobody has ever explained to me what they are exactly. Well, it is pretty simple, think about a mutual fund…and then remove most of the rules. Hedge funds are allowed to use much larger leverage (borrowed money). Since the borrowing restrictions are not in force, hedge funds, are allowed to take much much more risk than most mutual funds are allowed.

With all the added risk hedge funds are allowed, there are restrictions. Hedge funds are only available to accredited investors and institutions. Accredited investors are just people who make enough money or have saved enough money that they are deemed by the government to be investing at their own risk. By restricting investment to these two groups, regulators are in effect saying “invest at your own risk.”

Hedge funds in 2016 have had an amazingly bad year as a whole. In the first half of 2016 investors pulled $60 billion from the total assets under hedge fund management. As of mid-October all registered U.S. hedge funds are averaging 4.1% return whereas the S&P 500 is up 8%. (Hedge Fund Research Composite Index) Some of the largest investors in the world such as CALPERS removed hedge funds in total from their portfolio. And on top of that, it appears hedge funds are losing a bet to Warren Buffet.

Back in 2008 Buffet hatched a million-dollar bet with management at Protégé Partners. Buffet bet that the Vanguard S&P 500 fund would beat a basket of five hedge funds picked by Protégé. There are still about two years left on the bet, but the lead the S&P has over Protégé seems insurmountable. In the eight years since the beginning of the bet, the S&P is up 66% whereas basket of hedge funds picked by Protégé has performance less than 1/3 of the return at 21.9% (May 2016).

So why are hedge funds doing so poorly? Obviously each individual fund has its own issues and some of them are doing great. But as a whole, the first, second and third problems with hedge funds are fees, fees, and fees…in that order.

To be clear, hedge funds were not always a horrible investment. During the most modern iteration of this investment vehicle there was some logic involved in picking an investment that had fees much much higher than standard mutual funds or indexes. Hedge funds could borrow money and expose investors to higher risk. They could use that extra leverage and incorporate new technology such as super computers and advanced algorithms to sift through previously unknown opportunities. They could trade in and out of securities at lightning speed without worry of regulators looking over their shoulders.

But today, supercomputing and advanced math are the norm across the industry, available to even the smallest of investors. Most of the hedge fund “ideas” that are pitched to our firm these days are regurgitated ideas of the past, and it seems that much of the extra fees are being spent on slick salespeople rather than slick ideas. The brain trust at Vanguard and iShares will stack up against the best at Bridgewater Associates or AQR Capital Management. When everybody is doing “it”, it is no longer and advantage.

Many of the hedge funds we see are invested in hundreds of different companies. And the average hedge fund investor doesn’t just have one hedge fund…they normally have three to five of them. If you have three to five investments that each invest in hundreds of different securities, you really have just bought an index. Albeit an index that is charging fees 20 to 100 times as much as the standard index fund. The math simply cannot add up. If you are paying enormous fees, you may luck out and have a few years where your investment outperforms, but eventually the math should catch up. Nobel Prize winner Eugene Fama has done some good work detailing how luck plays a bigger role in performance than skill. Fama

Most portfolios, for most investors should be made up primarily of index funds with very small fees. Almost all of the funds that our firm uses have fees of 0.18% and lower. Extremely low cost funds are readily available to even small investors. If you use a broker, ask them what total expenses are on your investments. Total cost is purchase cost (commission), advertising fees and expense ratio combined. If that number is above 0.5% I would suggest walking out of the meeting.

 

Article by: Adam Faust, Founder & Principle at Deep Blue Financial LLC