Want To Invest In A Hedge Fund? Think Again

Includes: IVV, MDY, RSP, SPY, VOO
by: Jeff Gonion

Hedge Funds- the investment vehicle of the high net worth investor and uber-rich alike, with investments decisions determined by Wall Street wizards and super-computers. No wonder why the rich keep getting richer. Ahhh, the fantasy of being the "smart money".

Back in the real world, Wall Street wizards and super-computers are expensive. So are audits, administrative fees, taxes, accounting, compliance and legal advice. All of this is paid for by the investors in the hedge fund, in the form of management fees and performance fees.

Management fees in most hedge funds run between 1.5 - 2% of assets under management. Not bad, considering that a lot of financial advisors charge 1% as well. Performance fees typically run around 20%, but only on profits made during the year.

Consider the typical "2 and 20" hedge fund, so-named because of the 2% management fee, and a 20% performance fee. Imagine you invest $1M in such a fund, which gained 10% ($100K) over the course of the year. After deducting a management fee of 2% ($20K), and a performance fee of 20% (another $20K), you would be left with only a $60K gain, or a 6% ROI.

The conventional wisdom is that hedge funds "beat the market", justifying the exorbitant fees, and the investor in the hedge fund still makes-out better after the fees. After all, if hedge fund investors didn't beat the market, they would pull-out their money, and hedge funds wouldn't be a $2 Trillion industry. But reality and conventional wisdom don't always align.

Hedge Fund Research (HFRI) is a company that gathers data from thousands of hedge funds, categorizes and indexes the data, and reports on the performance of these funds. There are a number of companies that report similar data, but I chose HFRI because they also report 3-year and 5-year annualized returns.

The table below compares the performance of equity-based hedge funds with the performance of three funds that represent the S&P 500 index (NYSEARCA:SPY), the equal-weight S&P 500 index (NYSEARCA:RSP), and the S&P 400 mid-cap index (NYSEARCA:MDY), over 1-year, 3-year, and 5-year periods.

Fund 1-Yr 3-Yr 5-Yr
SPY 5.41% 27.82% 1.47%
RSP 3.82% 34.28% 2.69%
MDY 2.19% 34.38% 4.29%
HFRI Equity Hedge (Total) Index -3.71% 11.61% 1.42%
Equity Market Neutral Index -0.90% 1.77% 0.50%
Quantitative Directional -3.50% 9.35% 0.76%
Energy/Basic Materials Index -15.56% 13.41% 0.65%
Technology/Healthcare Index 2.33% 13.45% 6.69%
Short Bias Index -8.85% -20.12% -5.10%
Click to enlarge

Overall, investors in equity-based hedge funds fared worse than investors that simply invested in index funds. Looking across the entire universe of hedge funds, the results are similar for non-equity focused hedge funds. The bottom-line is that most hedge funds don't beat the market, especially after fees.

Note: The hedge fund data in the table above is from HFRI. This data, as well as performance data on other types of hedge funds can be found on their website.

Disclosure: I am long RSP, MDY.