Basically the title. Hedge funds underperform every year as compared to broader ETFs like S&P500 by more than 10%! Given this, who invests in hedge funds? Are they stupid or am I stupid?
[https://www.aei.org/carpe-diem/the-sp-500-index-out-performed-hedge-funds-over-the-last-10-years-and-it-wasnt-even-close/](https://www.aei.org/carpe-diem/the-sp-500-index-out-performed-hedge-funds-over-the-last-10-years-and-it-wasnt-even-close/)
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They’ve been making terrible bets since 2016 or so, in the past year certain hedgefunds have lost billions.
But someone who has millions in their investment account doesn’t want to worry about anything stock related so they go to the biggest fund. They think oh this fund has lots of money, (in reality they have illiquid assets) they’ll give me returns.
A good example is Michael Jordan whose net worth dropped 500 million in a single year and it’s speculated that it was from a bad bet shorting GME.
Hedge funds when viewed collectively, i.e. “on average”, underperform the index over a number of years. There are some hedge funds that outperform the index over a more limited time.
Those that keep underperforming usually wind down because investors keep withdrawing money from them.
However because there are always some hedge funds posting decent returns for a small period, that attracts investment from people who either believe the fund can do better than the index in the next period as well, or because they want to diversify in some way and think allocating some money to this fund can be part of their overall investment mix.
In short, its a combination of hope (greed?) and diversification.
the returns of the hedge funds include “fees, costs, and expense”. for a big investor, a lot of these expenses can be waived or lowered. for the average simpleton, then yes, it’s better off just investing in the index fund.
also, that report only includes a very tiny selection of a few hedge funds, there are many out there that we just won’t know the performance of, because they aren’t telling anyone.
but in general, it’s possible for hedge funds to seriously out perform the market because they aren’t constrained in what they can invest in. for example some hedge funds got in on (or maybe even caused) the crypto boom.
so at the end of the day. hedge funds can be akin to “nontraditional medicine or dietary supplements or magic weight loss pills”. many believe in it, many will call it scams, many will try it, it will work for some and not work for others. but at the end of the day, there’s no hard science/data to back any of it up.
Hedge funds can do a lot of extremely high risk stuff like leveraging their capital to eye watering levels to make risky bets, or shorting the same stock multiple times over to such a degree that the short bet itself causes the stock to crash in value. Because of the wealth of the individuals who are funding this, the system is rigged to ensure that if these massive risky bets go awry, the losses don’t actually come.
Most of this happens behind closed or opaque doors so the general public is not overly aware.
I personally know a hedge fund owner who made his clients nearly 100% return last quarter. Not all funds suck. You only hear about the ones that do.
Lottery numbers are (on average) mostly useless for making money. But sometimes, lottery numbers can win zillions of dollars.
Hedge funds are like a less-dramatic version of lottery numbers. They will (on average) be mostly useless for people who want a bigger return than average. But there are enough hedge funds out there that some small number of them just by pure luck will be doing better than the average market return, just like there’s a small set of lottery numbers at any given time that will just by pure luck be very good for people who picked them. People who pay someone to pick stocks are just playing the lottery, with extra steps.
Think about it this way: if the hedge funds *could* reliably beat the average market return, why would they sell that information to you instead of just doing it themselves? It’s like writing a book called “how to make a million dollars,” with step 1 being “write a book about how to make money.”
One of the things hedge funds handle is volatility. You could be a pension fund that’s happy with 6% returns as long as there’s minimal volatility. That’s where hedge funds come in.
The 10% long term returns you see for SPY will include a year every now and then where the market is down 20% or so. Pension funds would like to avoid that and will compromise on long term returns to that end.
A hedge fund is exactly as its name suggests. It is generally structured to hedge against market volatility. When the nether goes up it doesn’t appreciate as fast but when markets retreat, it preserves capital. It’s for folks who have a lot of money who want to hold on to it as opposed to most folks who are looking to grow their monies and need to take higher risks to get higher returns
Hedge funds, as the name indicates, are intended to hedge the market exposure. They use strategies that (should) produce returns uncorrelated with the overall market.
This is a massive benefit from the standpoint of diversification. You can greatly reduce the volatility (i.e., risk) of your overall portfolio by holding uncorrelated investment vehicles – e.g., hedge funds and market index. When the market goes down, the hedge fund investment may offset your losses by going up, and vice versa. (Notice that this does *not* reduce your expected returns, only the risk!)
These sort of market-risk-free instruments tend not to appear “naturally” on the market, but have to be produced synthetically with sophisticated methods. Hence, investors are willing to pay a big price for them.
Though, if the constant underperformance does continue, it is bound to have an effect on investors willingness to invest in hedge funds, as you mentioned yourself.
Why buy an ETF of the S&P if just buying TSLA or AAPL beats it? Well, because you’re not sure what’s going to be the best stock in the future, so you buy a bunch of difference ones (the S&P) because the diversification improves your risk adjusted return. In the presence of uncertainty, you make a bunch of (somewhat) uncorrelated investments instead of just putting all your money in one thing.
Same idea with hedge funds – the goal of many (most?) hedge funds is not to beat the S&P, but to provide returns uncorrelated to it. A mix of long equity, credit, macro etc investments has a better risk adjusted return than simply going long equity.
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