Can You Beat The Market Using Hedge Funds?

Can You Beat The Market Using Hedge Funds?

Vanguard, the large mutual fund company, recently released a study that attempted to answer the following two questions:

  • Do hedge funds consistently outperform standard market benchmarks?
  • Do hedge funds represent “alternative” investments with good diversification potential relative to stocks & bonds?

Vanguard’s conclusion:  “No” to both questions.

Titled “A mixed bag: Performance of hedge fund categories before and after the financial crisis,” the study’s authors looked at average hedge fund returns across nine different categories (such as emerging markets, equity market neutral, and managed futures, to name a few) over two periods: November 2007 through February 2009 – the period in which the S&P 500 fell over 41% – and March 2009 through December 2011, when equity markets recovered.  They compared those returns to a 60% stock/40% bond portfolio (based on the S&P 500 and the Barclay’s Aggregate Bond indices) as representative of a typical investor’s portfolio.

The authors found that although most hedge fund categories enjoyed outperformance versus broad U.S. equity and bond benchmarks during the market downturn, none of the hedge fund categories fully participated in the market recovery.  In other words, hedge funds outperformed during one period, but underperformed during the other.

The study also found that many hedge fund categories were highly correlated with a 60%/40% portfolio of stocks and bonds over both periods, indicating that there would have been little benefit in utilizing such hedge funds to diversify and reduce portfolio risk.

The authors additionally point out some of the difficulties in measuring hedge fund performance in general.  Survivorship bias – the tendency for underperforming hedge funds to close or otherwise disappear through acquisition – can lead to measured results that are higher than what actually occurred.  While this can be a problem with publicly-traded mutual funds as well, the lack of transparency and less stringent regulations with hedge funds make their measurement particularly challenging.

Interestingly, you can now invest in publicly-traded mutual funds and ETFs – alternatives to hedge funds – in virtually all the same categories as the hedge funds that were studied.  Although the Vanguard study was only conducted over a relatively short time frame, it should at least encourage prospective hedge fund investors to consider whether a hedge fund’s potential returns will truly outweigh its limited liquidity, significantly higher fees, and reduced transparency.

The Vanguard study can be found at http://us.vocuspr.com/newsroom/ViewAttachment.aspx?SiteName=vanguardnew&Entity=PRAsset&AttachmentType=F&EntityID=1061988&AttachmentID=cff948b1-f75b-475e-99d9-71767c66c3c5

 

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