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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You’re talking about the average. Some do much better than average, some do much worse. They survive because people will always be willing to take a risk to do better than average.
The purpose of a hedge fund is not to beat the market. The purpose of a hedge fund is to generate alpha – or consistent returns uncorrelated to the market. Good hedge funds like Citadel or Millennium generate roughly the same amount of returns every year regardless of what the market does in that year. This needs some explanation.
In finance language, the returns of the market are called beta. You can buy beta through an ETF like the S&P 500. Hedge funds try to eliminate beta by being long and short the same amount of stock. Assuming nothing else changes except the market goes up/down, then your position should be unchanged except you also pay fees so you end up losing money. A good hedge fund is long better companies and short worse companies, so if the market goes up your longs go up more than your shorts; and vice versa if the market goes down
Many hedge funds call themselves hedge funds but are not actually hedged. This is extremely bad. Beta as you have identified, is essentially free because ETFs cost no fees. If your strategy is to be 90% the same as the market and 10% different; then you should only be charging fees for the 10%. Imagine the market returns 10% and you return 12% with the above strategy; your alpha is only 2% and since you charge 2% fees – you generate nothing for your client.
The existence of hedge funds allows larger pension funds and endowment funds to do this themselves. They can hold 90% of the fund in ETFs and long only funds and give themselves upsized alpha using the remaining 10%; or whatever configuration they feel like.
The problem is that over the last 10 years, markets have only been going up because of the low interest rate environment. This means nearly by definition, hedge funds (except the very best ones) should be losing to the market. In more volatile times like now, the average returns for hedge funds is a lot more impressive.
This is a major oversimplification of course – but hopefully useful.
Because hedge funds are a different type of asset class compared to stocks…. you wouldn’t ask why people prefer us t bills to stocks, we understand that risk is rewarded in the market… hedge try to make alfa (non market risk) using any instrument that they are allowed by their investment charter while stocks and index make money on beta (market risk)… beta pays better than alfa but is also more risky
Bonds underperform equities but investors still buy them because there is less risk.
Same thing with hedge funds, which in theory “hedge” your bets so there is less risk involved and investors are willing to accept the lower returns for the lower risk.
On a risk adjusted basis, hedge funds do out perform the s and p 500
It’s literally in the name “hedge”. These funds are used by rich people to hedge their investments in the overall market not to actually outpace the returns in them.
Remember, that underperform percentage is the AVERAGE.
Some performed very well, profiting 50%+++ /year
There are other things to optimize for than returns. If you’re trying to live off that money and the market tanks something fierce for a year before bouncing back you could heavily erode your capital. in that case you may want to optimize for risk or different types of risk or something in between
I love when I see a question like this in eli5. Have you guys ever talked to a five year old?
Here’s the 5 year old explainer: people who have lots of money get told by people who want their money, that they can make more money by giving it to them.
There’s a whole lot less rational behavior in the world than economists would have you believe there should be.
2009-2019 was the biggest bull market in history. The S&P 500 returned close to double digits every year. You could not lose money regardless of where you put it. In these years, simply betting the market as a whole is the best way to make money, since you are skipping the big cuts that fund managers take for themselves.
If you run the same numbers starting 2020, things will look a lot different. When there is market volatility, these investors can use advanced techniques and monetary instruments (shorts, commodities, currencies, crypto, futures trading) to try and cut losses or generate gains. That’s when the value of hedge funds becomes apparent.
as someone who spent several years at a big box investment firm (not a hedge fund) engaging with institutional investors regularly, the real answer is institutional investors don’t buy returns, they buy “cover-your-ass-ability.”
there are usually 1-4 people as a group making decisions at the final stages of mandates. hedge funds are attractive to these people because 1) they can talk about their alpha (outperformance relative to market) strategy to their bosses, which justifies their expertise and big paycheck (even if that alpha never seems to materialize) and 2) if things blow up, you can deflect some blame on these guys that were supposed to be so damn smart.
lastly, there is a good amount of cachet for some people in meeting/investing with a HF, and you’d be surprised how much that drives decision making sometimes.
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