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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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.
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.
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