Is the party over for hedge funds?

This weekend's Barron's has an article (paid subscription required) titled For Hedge Funds, Is the Party Over?. Author Lawrence Strauss argues that excessive asset inflows, rising fees, market correlation, declining average management talent, fraud and blow-ups are making hedge funds less attractive. But Mr. Strauss omits possibly the most important factor:

Here's a chart of the CSFB-Tremont Long-Short Equity hedge fund index compared to the S&P 500, the Russell 2000 and the MSCI World equity index:


This chart shows that the CSFB-Tremont Hedge Fund Index has generated similar, but smoother returns than the S&P 500 in the ten years since 1994.

Now here's a chart illustrating the key benefit of hedge funds: low "draw-downs", namely lower volatility and risk of loss than standard equity indicies:


Here's what concerns me so much about these charts:

  • All indices are pre-tax. But that means that a buy-and-hold strategy with an S&P 500 index fund would have massively outperformed investing in hedge funds for tax-paying investors, particularly those in high tax states and local jurisdictions.
  • The hedge fund index used here does not include the additional fees for a funds of funds that would allow you to invest in multiple hedge funds. With those added fees, the hedge fund index would have underperformed the S&P 500 even on a pre-tax basis.
  • A simple rebalancing strategy with index mutual funds or ETFs would have greatly reduced the draw-downs from an index strategy, and boosted returns. I discuss portfolio rebalancing with index funds (specifically ETFs) here.

Bottom line: for taxable investors, an index-fund-plus-rebalancing strategy would have provided far better results than investing in hedge funds over the last decade.

In the next post I hope to discuss the findings of the Hennessee Group's annual survey of hedge fund managers, and raise some issues about funds of funds.