Are Hedge Funds Overrated?

Some of the biggest hedge funds are not only sitting on negative returns for the year, but they are performing no better than simple, diversified mutual funds available to everyday investors.
Yes, the market did just see (or is still working its way through) its biggest correction in years, but shouldn’t hedge funds be doing a good job of, well, hedging?
To be fair to hedge fund managers, their primary objective is not necessarily to beat the major market indexes but to achieve positive returns in any market environment. To do this, they will combine long and short positions, and they typically have the combination of timing and skill that will make them right more often than they are wrong.
So how did the big hedge funds do during the recent market meltdown?

Hedge Funds Scorecard: 2015 Market Correction

Here’s a quick overview of how hedge funds performed during recent market volatility, according to The New York Times:

• Hedge funds with higher relative allocation to long-term holdings have tended to fare the worst the past month and year-to-date.
• Omega Partners, a $9 billion hedge fund run by Leon Cooperman, is down 8% this year.
• Greenlight Capital, an $11 billion fund run by David Einhorn, is down 14% this year.
• Pershing Square, a $20 billion fund run by Bill Ackman, is down 0.1% percent for the year.
• The average hedge fund, as measured by the HFR Index, is down about 1%.
• Hedge funds that fared best in August, and year-to-date, are those that bet against the market with more shorts than longs.
• Among the standouts is a $31.5 billion fund run by Israel Englander, Millennium Management, which is up 9.6% for the year.

In summary, and not surprisingly, the hedge funds that are doing best year-to-date are those that bet against the market, and the ones doing the worst were caught with too many long positions.

But Who Needs Hedge Funds, Anyway?

With high barriers to entry, most investors don’t have access to hedge funds. But are hedge funds worth the cost? Many hedge funds require at least $1 million in assets to invest and charge fees of around 2% to investors after taking cuts of profit of up to 20%.
With the average hedge fund down around 1% for the year, an investor could get comparable returns with a conservative balanced fund like Vanguard Wellesley Income Fund (VWINX), which is down 1.9% year-to-date.
Speaking of Vanguard funds – and how everyday investors can use simple diversification in turbulent times – consider a few points from a Vanguard study on the performance of hedge funds during the Great Recession:

• During the bear market, between November 2007 and February 2009, an index of hedge funds had a negative 1.6% return, whereas an index mutual fund with a 60/40 equity/bond allocation produced a comparable negative 2.3% return.
• During the immediate bull market recovery, between March 2009 and February 2010, the index of hedge funds had a 0.8% gain, whereas the 60/40 index fund had a better gain of 2.6%.
• Although the average hedge fund did minimize downside risk during the turbulent period, investors would still have to choose a particular hedge fund, or a fund of hedge funds, and would thus face a much higher risk than investing in a hedge fund index.

To add my own suggestions to this comparison between hedge funds and the timeless wisdom of asset allocation and passive investing, an investor could simply buy a balanced index fund like the appropriately titled Vanguard Balanced Index Fund (VBINX) and continue to dollar-cost average into shares – even as the market is falling – and potentially produce greater returns than hedge funds.
It is my educated guess that the people who are making good money off hedge funds are the hedge fund managers. Everyday investors, or even the multi-millionaires looking for solid long-term returns, can stick with low-cost mutual funds and do as well or better than hedge funds.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. He personally holds no positions in any of the aforementioned securities, although he holds VWINX in some client accounts. Under no circumstances does this information represent a recommendation to buy or sell securities.

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