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Day three of our lessons from 2013, we'll dive right in with an examination of hedge fund returns. You can find Part II here.

Lesson 7: Hedge Funds are not Investment Vehicles, they are Compensation Schemes

This one holds the title with the most repeat performances, appearing most years. The HRFX Global Hedge Fund Index earned just 6.7 percent. The table below shows the returns for various equity and fixed income indices.

Benchmark Index

2013 Return (%)

Domestic Indexes

S&P 500

32.4

MSCI US Small Cap 1750 (gross dividends)

39.1

MSCI US Prime Market Value (gross dividends)

31.9

MSCI US Small Cap Value (gross dividends)

33.7

Dow Jones Select REIT

1.2

International Indexes

MSCI EAFE (net dividends)

22.8

MSCI EAFE Small Cap (net dividends)

29.3

MSCI EAFE Small Value (net dividends)

31.6

MSCI EAFE Value (net dividends)

23.0

MSCI Emerging Markets (net dividends)

-2.6

Fixed Income

Merrill Lynch One-Year Treasury Note

0.3

Five-Year Treasury Notes

-1.1

20-Year Treasury Bonds

-11.4

The HFRX Global Hedge Fund Index underperformed all but two (U.S. REITs and Emerging Markets) of the major equity asset classes. An all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned 24.2 percent. And a 60% equity/40% bond portfolio with those weights for the equity allocation would have returned 14.6 percent using one-year Treasuries, 14.1 percent using five-year Treasuries, and 10.0 percent using long-term Treasuries. Given the freedom to move across asset classes that hedge funds tout as their big advantage, one would think that "advantage" would show up. The problem is that the efficiency of the market, as well as the costs of the efforts, turns that supposed advantage into a handicap.

Over the long term, the evidence is even worse. For the 10-year period from 2004-2013, the HFRX Index returned 1.0 percent per year, underperforming every single equity and bond asset class. The table below shows the returns of the various indexes.

Annualized Returns 2004-2013

Domestic Indexes

S&P 500

7.4

MSCI US Small Cap 1750 (gross dividends)

10.4

MSCI US Prime Market Value (gross dividends)

7.4

MSCI US Small Cap Value (gross dividends)

9.4

Dow Jones Select REIT

8.2

International Indexes

MSCI EAFE (net dividends)

6.9

MSCI EAFE Small Cap (net dividends)

9.5

MSCI EAFE Small Value (net dividends)

10.1

MSCI EAFE Value (net dividends)

6.8

MSCI Emerging Markets (net dividends)

11.2

Fixed Income

Merrill Lynch One-Year Treasury Note

2.1

Five-Year Treasury Notes

4.3

20-Year Treasury Bonds

6.1

Perhaps even more shocking, during this period the only year that the HFRX index outperformed the S&P 500 was 2008. Even worse, compared to a balanced portfolio of 60 percent S&P 500 Index/40 percent Barclay's Government/Credit Bond Index it underperformed every single year.

For the 10-year period an all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned 9.2 percent per year. And a 60% equity/40% bond portfolio with those weights for the equity allocation would have returned 7.1 percent per year using one-year Treasuries, 8.2 percent per year using five-year Treasuries, and 9.4 percent per year using long-term Treasuries.

Lesson 8: Last Year's Winners are Just as Likely to be this Year's Dogs as they are to Repeat.

The historical evidence demonstrates that individual investors are performance chasers -they watch yesterday's winners and then buy (after the great performance), and they watch yesterday's losers and then sell (after the loss has already been incurred). This causes investors to buy high and sell low - not exactly a recipe for investment success. This behavior explains the findings from studies that demonstrate that investors actually underperform the very mutual funds they invest in.

Unfortunately, while there are streaks in asset class returns, they occur randomly relative to expectations. The streaks have no more meaning than streaks at the craps table - a good (poor) return in one year doesn't predict a good (poor) return the next year. In fact, great returns lower future expected returns, and below average returns raise future expected returns. Thus, the prudent strategy for investors is to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well - it adheres to its letter until it reaches its destination. Similarly, investors should adhere to their investment plan (asset allocation). Adhering to one's plan doesn't mean just buying and holding. It means buy, hold, and rebalance - the process of restoring your portfolio's asset allocation to the plan's targeted levels.

Using DFA's passive asset class funds the following table compares the returns of various asset classes in 2012 and 2013. As you can see, sometimes the winners of 2012 repeated, but other times they became losers. For example, in 2013 the top two performers in 2012, finished 9th and 11th out of the 14 funds.

Fund

2012 Return/Rank

2013 Return/Rank

DFA International Real Estate (DFITX)

33.4%/1

2.3%/9

DFA Emerging Markets Small (DEMSX)

24.4%/2

-1.4%/11

DFA International Small Value (DISVX)

22.3%/3

32.4%/4

DFA U.S. Large Value ((DFLVX)

22.2%/4

40.3%/3

DFA U.S. Small Value (DFSVX)

21.7%/5

42.4%/1

DFA Emerging Markets Value (DFEVX)

19.4%/6

-3.8%/13

DFA Emerging Markets (DFEMX)

19.2%/7

-3.1%/12

DFA International Small (DFESX)

18.9%/8

27.4%/6

DFA U.S. Small (DFSTX)

18.4%/9

42.2%/2

DFA International Large (DFALX)

17.8%/10

20.7%/8

DFA Real Estate (DFREX)

17.5%/11

1.4%/10

DFA International Value (DFIVX)

16.8%/12

23.1%/7

DFA U.S. Large (DFUSX/S&P 500)

15.8%/13

32.3%/5

DFA Commodity Strategy (DCMSX)

1.3%/14

-9.1%/14

Lesson 9: Even With a Clear Crystal Ball

With the ability to foresee the news (though, not stock prices) with 100 percent certainty, one would think you could easily generate market-beating returns. But, is that really the case? If you knew on January 1, 2013, that the market would have faced the following hurdles, would you have invested in stocks?

  • Congress would be unable to agree on almost anything, including a budget agreement, putting the sequestration process into place. Many forecasters had predicted such an event would have negative consequences for the economy.
  • Congress would come perilously close to causing a default on government debt, only agreeing in the end to a very short-term solution regarding the debt ceiling.
  • Real growth in the economy would fall to just an estimated 1.7 percent, continuing to be the weakest recovery in the post-war era.
  • There would be major problems with the implementation of the Affordable Health Care Act, creating uncertainty for the economy.

These are just some of the many hurdles the market had to overcome in 2013. Yet, the S&P 500 rose 32.4 percent for the year.

My next post will be a conclusion of the hefty lessons learned this past year. We'll pick up with a lesson on dividends.

Source: Lessons From 2013: Part III