Mark Gongloff finds this astonishing chart in a Morgan Stanley note this morning. It shows the degree to which hedge fund returns, in aggregate, are correlated with our old friend the S&P 500. And it turns out that even though the correlation has never been higher, it’s still somehow rising.
Now this isn’t all hedge funds — it’s just looking at the HFRI Equity Hedge index. That index covers, broadly, any hedge fund which invests mostly in stocks — but is entirely agnostic as to whether you’re long or short. It includes market-neutral funds, which aspire to be uncorrelated with the market; it also includes short-bias funds, which aspire to a negative correlation with the market, at least in times when the market is rising. And it also includes things like quantitative directional funds, which are algo-driven and tend to make momentum plays rather than long-term investing decisions.
And yet, look at the performance of all those funds put together, and it turns out to almost exactly mirror the performance of the S&P 500.
The result is predictable:
Once upon a time, according to this chart, hedge funds playing in the stock market actually outperformed the S&P 500. They did so during the dot-com bubble, and they did so after the bubble, too. You can quibble about what exactly is being measured here, and survivorship bias, and performance fees, and things like that. But whatever’s being measured, it’s now gone negative. Put all the smartest hedge-fund managers together in a room, tell them to go out and make lots of money, and over the past five years you would have been better off in an index fund.
As Gongloff says, “the current market environment of extreme correlation has made it nearly impossible to pick stocks well”. And this has lessons even for those of us who simply invest in index funds, too. A lot of financial advisers get quite excited about diversifying index funds — rather than just investing in the S&P 500, you should invest in a growth fund here and a value fund there and an emerging-markets fund and a large-cap fund and a small-cap fund and probably a RAFI fund or two just for good measure.
But the one thing you can be quite sure of, when it comes to all these clever ETFs and index funds, is that they have significantly higher fees than your bog-standard S&P 500 index tracker. And with correlations where they are, it’s increasingly difficult to believe that there’s much if any reason to pay those higher fees. Even if they’re a lot lower than the 2-and-20 charged by the HFRI crowd.