Tuesday, January 14, 2014

A Bad Comparison: Hedge Funds Trail the Market

A Bad Comparison: Hedge Funds Trail the Market

Last week Bloomberg featured a story entitled “Hedge Funds Trail Stocks for Fifth Year With 7.4% Return.”[1]  I’ve seen this kind of headline in numerous publications in the last several weeks. In addition, I’ve heard various critics of the hedge fund industry cite these performance statistics as evidence that hedge funds are bad investments.  Although I spend a fair bit of time on this blog criticizing hedge funds, the comparison of hedge funds to the S&P 500 or stocks is totally misguided.
Basic Questions (1999)

Let’s begin with the fact that hedge funds aren’t an asset class, while stocks, of course, are.  A hedge fund is a lightly regulated investment vehicle that can invest in a wide variety of strategies.  Bashing hedge funds for underperforming the stock market is as ridiculous as saying that mutual funds trail the stock market.  Since mutual funds or regulated investment companies invest in a wide variety of different asset classes, a broad comparison of their performance to stocks makes no sense.  It’s only appropriate to compare large cap stock funds to the S&P 500.

There are hedge fund strategies for which a comparison to stocks is appropriate.  However, it is a relatively small subset of all hedge funds.  If a hedge fund has substantial exposure to stocks, then its performance should be benchmarked against the market.  For other hedge fund strategies, bond indices make are far a more appropriate comparison.  In some cases the benchmark needs to be a combination of stock and bond indicators.  And for some hedge funds, it is difficult to come up with any benchmark at all because it is involved in strategies that bear little similarity to conventional stocks and bonds.

Hedge fund managers make the same mistake.  When hedge funds beat the stock market, they like to trumpet the superiority of hedge funds.  The comparison is nonsensical whether hedge funds are beating or trailing the stock market.  Unfortunately, hedge fund managers have used the comparison to steer investors out of stocks and into their products especially at the bottom of bear markets.

My problem with hedge funds is the same problem I have with most active money managers.  They charge too much, and on average they don’t add any value.  In the case of hedge funds, the problem is even bigger because their fees tend to be substantially higher than those of conventional money managers. 

Hedge funds should receive a high level of scrutiny.  However, inappropriate comparisons don’t foster a greater understanding or a healthy debate.

[1] http://www.bloomberg.com/news/2014-01-08/hedge-funds-trail-stocks-for-fifth-year-with-7-4-return.html

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