Hedge Fund Folly

2017 was not the best for hedge funds. The average hedge fund returned 8.5% for the year, which isn’t all that bad if the risk-adjusted returns aren’t taken into consideration.1 But when you compare it against the S&P 500 return of 21.8%, it’s an embarrassment to an industry that markets its services based on the skill of its managers. A folly of sorts since skillful fund managers are few and far between. The investing public at large is disqualified from investing in hedge funds, and that’s probably a blessing in disguise. It’s the institutions and the high net worth individuals that are uniquely qualified to take their chances, roll the dice, and pray that their millionaire managers can outperform a simple index fund.

This is not to say that hedge funds can’t outperform, indeed many hedge funds return in excess of the S&P 500, or any other benchmark that they’re measured against. Whale Rock Capital and Light Street Capital, two relatively smaller hedge funds, returned 36.2% and 38.6, respectively in 2017. But the hard part is selecting which fund will outperform on an annual basis because this year’s winner tends to become next year’s loser.

Pershing’s peril

Bill Ackman’s Pershing Square Capital Management returned an outstanding 40.4% in 2014, and money poured into his fund resulting in a massive increase in assets under management (AUM). He literally became the golden boy of the hedge fund industry over night, despite the fact that his previous fund imploded in a somewhat disastrous fashion. Bill Ackman is a marketing genius, though. His public assault on Herbalife made headlines for months, his appearances on CNBC were nothing short of entertaining, and his marathon presentations on his activist positions only added to his popularity. The year after his great run which beat the S&P by 26.7%, he saw a 60% slide to the negative, and investors went elsewhere with their money. Each year since then has only driven investors away and Ackman’s AUM has fallen by the billions.

Is Bill Ackman a talented investor? Yes, to a certain extent he is. He has taken great positions in companies and actively sought to turn those companies around. Is Bill Ackman a master marketer? Absolutely. Had you invested with Ackman through thick and thin since 2013, you would’ve made an abysmal 17.1%, before his outrageous fees. Net of fees, you would’ve lost to inflation with just a 1.4% gain from January 2013 to November 2017. The S&P returned 100.1% during that time, and the fees for investing in that fund did not make the manager a millionaire, let alone a billionaire like in Ackman's case.

The fee paradox

So if hedge funds aren’t producing superior returns why do they still attract money? In our opinion, it comes down to exclusivity. Wealthy investors want to separate themselves from the masses, even if it means putting more money at risk without any long-term assurance of decent returns. It’s almost a mathematical certainty that hedge managers won’t be able to beat an index fund after accounting for their 2 and 20 fee structure. The industry has traditionally taken 2% of AUM and an additional 20% of profits which makes it that much more difficult to continually beat the market. A basic index fund available to your Average Joe can be had for just 4 or 5 basis points, which is nearly 97% cheaper than the average hedge fund. Still, money continues to flow into the hedge fund industry with just over $3 trillion in AUM as of this writing.

We’ll end with a very revealing chart of hedge fund investing: The relative performance of the average HF vs. the S&P over the past 12 years ending in 2017.2 Only 2 of those 12 years have outpaced the S&P, so the next time someone brags about being invested in “alternative” funds, the chances are they’re losing to the guy next door who invested in the most basic of funds.

1 https://www.investopedia.com/news/2017-hedge-funds-return-less-half-sp-500/

2 https://www.theatlas.com/charts/ByYxH-w8f