Hedge Funds Are Not Necessarily for Suckers

(Originally published here.)

The cover of this week’s issue of Bloomberg Businessweek is visually arresting:

There are plenty of good reasons for savers to avoid hedge funds. Some of the most common arguments, however, fall short of the mark.

Many complain that hedge funds have done worse than a simple basket of U.S. equities, such as the S&P 500 index. Here is a chart comparing the performance of an investor who had put $100 in the S&P 500 index and reinvested all of her dividends against the performance of the entire universe of hedge funds, according to Hedge Fund Research:

Source: Bloomberg

Source: Bloomberg

As you can see, the basic index fund did better over the past decade.

That tells us relatively little, however. It’s easy to find periods when certain asset classes did better than others. For example, someone who had put all of his savings into gold bullion in the middle of 2001 would have increased his wealth by more than 600 percent over the following decade. By contrast, someone who owned shares of the S&P 500 stock index and reinvested all dividends would have made a little less than 20 percent over the same period — and that’s before taking inflation into account:

Source: Bloomberg

Source: Bloomberg

Of course, anyone paying attention to the markets knows that stocks have dramatically outperformed gold in the two years since. As far as I can tell, this just shows that things go up and down. It doesn’t tell us anything about how to best allocate our savings.

More important, there are many different types of hedge funds doing very different things. Some identify fraudulent companies that they bet will fail. Others try to anticipate what central banks will do and trade interest rate futures and currencies. Then there are the “quant” funds that trade according to complicated patterns observed in the data. It makes no sense to lump these funds together as if they were a single asset class and then compare them against a basket of stocks.

There are also many different managers within each category of hedge fund. Over short periods of time, the relative performance of different funds is mostly determined by luck. Skill becomes increasingly important as the time horizon lengthens, however. The performance of the “average” fund therefore doesn’t tell us whether or not there are funds worth investing in.

For most people, the best approach is to own things that all tend to go up over time but that move in different directions over shorter periods of time. You may even want to put some of your savings into things that tend to lose a little bit of money in the long run but that act like insurance when every other asset in your portfolio is sinking.

This framework also applies to savers considering potential hedge fund allocations. At the end of the day, all hedge fund managers make bets. The good ones make more money on the correct bets than they lose on the incorrect bets. If I find a guy who is good at sports betting and is willing to bet with my money in exchange for a fee, he is, for all intents and purposes, a hedge fund manager.

In fact, he would be a particularly desirable hedge fund manager because his performance would almost certainly be uncorrelated (or even negatively correlated) to the performance of everything else in my savings portfolio. Even if his absolute returns were lower than the returns I could get from buying and holding a stock index, I would still want to let him bet with some of my savings just so I could take advantage of those diversification benefits.

None of this is to say that you should give all of you savings to the first hedge fund that advertises in your local newspaper — and you certainly shouldn’t give your savings to mutual fund managers who promise to beat the S&P 500. But critics ought to be more careful when they make broad claims about the terribleness of hedge funds.

(Matthew C. Klein, a writer for Bloomberg View, formerly worked at the hedge-fund manager Bridgewater Associates. Follow him on Twitter.)


About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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