The dope on hedge funds: What 2023 tells us

At one point in my professional life, I started a hedge fund. It didn’t quite work out as I had hoped it might. I never reached the critical mass of investors to make it sustainable. Regardless, I learned a lot, and I’m glad I made the effort. My efforts notwithstanding, I’m now in the position where I can warn you away from investing in these kinds of ventures, hopefully, without it coming off like sour grapes.

Hedge funds employ a wide variety of trading strategies, frequently positioning with futures and options and other derivative instruments along with traditional stocks and bonds. In whatever market in which managers choose to operate, they try to assess the direction of coming price changes and then buy or sell, accordingly. (Unlike many other investment vehicles, hedge funds have the flexibility to allow them to take short positions.) Despite their efforts to call market price changes correctly, a high percentage of their trades often lose. The trick in successful trading is applying a discipline that constrains the losses on losing trades (a) to have sufficient capital to trade another day and (b) to try to assure that gains on winning trades end up being larger than losses on losing trades. If you can do that, even getting half of your bets “wrong” still allows you to have an overall profit.

For the most part, trading strategies of hedge funds are opaque, with disclosures and marketing materials giving managers a great deal of discretion to use their market judgment to buy and sell as they see fit. That being the case, investors and potential investors are generally ill-equipped to monitor when hedge funds try to do something different or when they’re following a consistent trading approach. And despite the mantra that past performance may not be indicative of future performance, rightly or wrongly, the track record of the fund is often the single most important factor determining whether investors would be willing to risk their capital with any given manager.

Generally, hedge funds are black boxes, where investors put up their money and hold their breath. They’re great businesses, however, for the operators. That’s because the fee structure is so incredibly generous to them — far more so than virtually any other professionally managed alternative. As typically structured, hedge fund managers get paid an immediate 2% of funds under management, and then they keep 20% of any profits the fund generates. Remember, all such fees come at the expense of the investors.

While by no means a comprehensive listing, Andrew Ross Sorkin of the New York Times recently published a short list showing the 2023 results for five fund managers who run some of the largest and best known hedge funds. Those results are reproduced below.

Keep in mind that this was a year in which the total return of the S&P500 came in at 26.29 percent. Thus, none of these superstars came close to beating the widely used benchmark for stock market performance. Granted, looking at one year may not be a fair representation of what these managers might be expected to return over a longer horizon, but this past year’s results are broadly consistent with the widely recognized finding that most money managers can’t consistently beat the performance of the S&P 500.

These various outcomes reinforce my view that the dominant exposure for any long-term investor should be a broadly diversified equity position, and this applies to both individual and institutional investors. My preferred instrument for achieving this exposure is the SPY contract, which is the most actively traded exchange traded fund (ETF). It allows investors to replicate the performance of the S&P 500 index with a single instrument that trades like a stock, whereby that market exposure is achieved extremely efficiently, virtually obviating management fees.

Nothing new here. I’m just reiterating a perspective originally articulated by John Bogel of the Vanguard Fund fame, which has been well understood and endorsed in academic circles for decades. In his time, Bogel was proselytizing on behalf of low-cost mutual funds that replicated the S&P 500 index. The SPY just improves on that concept further by trading with a more flexible and efficient investment vehicle than standard mutual funds.

I’m fully aware that many people feel ill-equipped to handle these kinds of investment decisions on their own and prefer to engage professional managers for these services. For those, consider this: Having your funds managed professionally isn’t an all-or-nothing proposition. Think about taking half of the money that you’ve placed with a manager and using it to buy SPYs, leaving the balance with your preferred manager. Not only will you save on management fees, but there’s a reasonable chance that you’ll also improve your overall returns.