Many people have heard that hedge funds have been a great investment for well-connected and wealthy people and institutions. A recent article in the Wall Street Journal that while this may have been the case from 1990 to 2009, hedge funds have seriously underperformed the S&P 500 since 2010 (Chung, 2019):
Table 14.1. Percent Return Above/ Below S&P 500
Source: HFR, Inc. and WSJ
A hedge fund is a mutual fund that by its mission and charter can invest in any multitude of assets. It can buy and hold stocks and bonds, but it can also sell short stocks and bonds; that is, it can make a bet that stocks or bonds will drop in price. Some hedge funds invest in commodities like gas and oil or corn and wheat. Some use people to pick the assets, but increasingly more and more are using computers to analyze tons of data to find assets to invest in.
The underperformance of the hedge funds hurts investors further by the exorbitant fees they charge. Normal mutual funds charge their investors 1% or less of assets annually. Hedge funds typically charge their clients 2% of assets annually plus keep 20% of the profits they make each year (called 2 and 20). Critics say this fee structure means that hedge funds are a vehicle to “transfer all the fund money from the pockets of the investors to the pockets of the fund managers.” Indeed, there have been a lot of billionaires minted out of hedge fund managers. So what happened to hedge funds?
- Quants and Index Funds: the increase in trading by computers and passive investing funds (like Index Funds and ETFs) have distorted the way stocks move. Currently, only about 15% of stocks traded are traded by humans. The quants’ computers can spot small mis-pricings in stocks and take advantage of them.
- Competition: there were just 530 hedge funds in 1990, and they managed $39 billion. Now there are 8,200 hedge funds managing $3.2 trillion of investors’ money.
- Stock Correlations: in recent years, stocks moved in correlation when financial news hit the market (such as a Federal Reserve Bank action), and this means less mis-pricing of individual stocks for hedge funds to take advantage of.
- Low Interest Rates: low interest rates keep shaky companies alive that would have died in higher interest rate environments. These are the companies that hedge funds sell short.
There seems to be no advantage to owning hedge funds now, so do not do it, even if you could.