Is Smart Money Really Smarter?

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by: Jesse Moore

Summary

Why have index funds outperformed hedge funds over the last 10 years?

Is it only a recent trend or a change in fundamentals?

Index funds will continue to be the most investor-friendly, long-term investment.

When I discuss my writing with friends, family, colleagues, and acquaintances, the first questions I receive from those without any idea of investing hit one of the following:

  • Can I make a fortune quickly?
  • What stocks should I buy?
  • Where should I put my money?

I will answer these three questions in different levels of detail below. Be forewarned that I prefer simple solutions over complex, and I often find a simple answer to nearly any question proposed to me. This article will be no different, but I will dig a bit deeper into the science behind the last (and more important) question.

Can I Make A Fortune Easily

There is no get rich quick scheme in the market (SPY) (unless you get lucky). I find this is an unfortunate hope from the majority of people I meet that have never seen a stock price, have no retirement savings, and would be what some would call 'financially illiterate.'

My answer - You can not spend a couple of nights looking for the right stocks, and make 10x your investment. Some investors spend their life looking for this event and never find it. Give up on this notion before you even start.

The but - I would not provide this part of my story to someone unless I knew they understood risk. As someone who effectively turned $1 into $25 in their early twenties, and that $25 into $100 (before turning that $100 into $30) on three different strategies I feel I can speak a little bit here.

First I was lucky. Then I was obscenely lucky. Then I was stupid. Sure I spent days upon days reading annual reports, forums, and every piece of information I could find, but luck still formed a significant part of it. Two times in a row I was able to find an arbitrage in a small market (small cap Australian stocks) far from the influences of 'smart money.' From these first few years investing, I began to formulate my ideas of what smart money was. I also started to realize that most of them weren't that smart, or had too much in assets under management to be much smarter than the economy itself.

So at the end of the day, you can make a small fortune - it requires a lot of effort, a lot of research/time, and a lot of luck. If you are missing any of those, you are doomed. Furthermore, sometimes you can be right, and still be wrong - I once shorted Santos on the premise that they required a capital raising, only to predict the raising three months too early. My short position was completely wiped out. Almost every analyst disagreed with me; even then, it didn't make me feel any better when the share price plummeted a few months later. In investing you are either right or wrong, and the numbers show it.

What stocks should I buy?

My advice here is simple as well. You need to be willing to put in hundreds of hours up front - learning the market, learning economics, learning what drives an economy, and learning how all that ties into a particular industry and stock. And that needs to be followed up by spending another 5-10 hours per week on your portfolio then you shouldn't be buying your stocks. Some people come across this knowledge through their careers, readings, and conversations - but many people invest with little or no knowledge of how the economy works.

A trend I am starting to notice of late is that more and more people are bringing a can't-lose attitude to investing. One of the longest bull markets in history will eventually come to an end, and as someone who has felt the pain of losing two-thirds of their portfolio, it is something I constantly worry about with today's valuations.

I'm not advocating someone shouldn't invest in stocks, but merely pointing out the time investment required to do it properly. Individual investors can often beat the market (as well as hedge funds) as they have far less capital, have far fewer rules, and can thus invest in places that 'smart money' can't.

Finally, after discussing to the above, I get asked:

Ok, Where should I put my money then?

This one is easy. An index fund. Go out, and buy an index fund with exposure to the broader market, and extremely low fees. Buy the same amount every month - buy when the market is depressed and when it is high.

Advice such as this has been given many times, and I am certainly not the one to come up with it. We have heard that index funds almost always outperforms the hedge fund industry overall, but I wanted to explore a bit more.

I found three datasets (hedge fund data, S&P 500 Price, S&P 500 Dividends) with the necessary data. Since 2000, the S&P 500 has outperformed in 116 of 210 analyzed months. I find that the S&P is more volatile, but also more likely to be positive. There were only a few months where it was drastically better to have been in a hedge fund. Perhaps those few months would allow the hedge funds to outperform over the long run?

Regarding total return since 2000, this is what $1,000 would have looked like in the average hedge fund vs. the S&P 500.

Not what I was expecting. Especially after all we have heard from investing greats such as Warren Buffet. The same thing happens when we compare to a well-known index fund such as Vanguard 500 Index Fund Investor Shares (VFINX) - the fund follows the S&P so closely it's not even worthwhile making another plot.

However, things start to look different later on. When we look at the above chart starting in 2000, we see something changes. The constant outperformance by hedge funds ceases around the Great Recession. After 2010, the average hedge fund began to underperform the S&P. Since 2010, the S&P has outperformed hedge funds 68% of the time - compared that with 45% before 2010.

Even if we start before the recession, the hedge funds will underperform in the long run despite a big head start.

What Happened To Hedge Fund Performance?

Hedge funds which had typically outperformed the S&P by a country mile ceased to do so. Given the data above, one could come to one of many conclusions:

  1. Hedge fund management deteriorated in the wake of the GFC.
  2. The lack of a bear market since the GFC, and the inability of Hedge funds to see the GFC coming have erased the typical outperformance exhibited by hedge funds in the long run.
  3. Market information became more readily available, increasing competition and decreasing arbitrage opportunities such as the ones I had found in my investing career. Since hedge funds have high fees, it is impossible for the net performance of the average hedge fund to match that of an index fund.

These are just my proposed reasons, and I'm sure there are others. I have to throw out my first idea immediately, as I doubt there was such a sudden change in HF that could justify the underperformance. Point two has some value but doesn't explain everything. Finally, we come to point three, and the information parity brought about by the maturity of the internet.

Hedge funds no longer hold the major advantage they once did. The internet is the great equalizer in markets, and as time moves forward, the information gap will close even more. I have information on copper traders, economic trends, stock prices, and news that would have been readily digestible for only a select few just a decade ago. I propose that the equal availability of information has resulted in the underperformance of typically high-fee hedge funds.

The Information Advantage

My final investing tip for those unlucky enough to seek my advice: if you are going to manage your investments, never make a trade that you do not feel you have more information or a unique viewpoint. The only way to beat the market is to find a sector, a company, or a macro-trend that others are not seeing. It doesn't have to be everyone, but you need to beat the majority.

Sometimes the market misses simple things, and those events can be arbitraged into a profit. A little over a year ago, I started writing extensively on copper when it was at $2.10. It was evident to me that the fundamentals of copper would drive it well over $3.00 through 2018. As I wrote, many disagreed with me - as well as nearly the entire industry. It took a year after my first article for the banks to turn bullish on copper, and by then I had already placed my bets.

This is a good example because it was not all that hard to find. I gathered the data, analyzed it, and came to my conclusions without reading those of the industry. That being said, I do not expect to be able to outperform the S&P forever (or as my funds grow). When the next bear market comes, you can be sure I'll be plowing into index funds - funds I will not be touching for decades.

Wrap-Up

Hopefully, readers come away with a bit of perspective on why hedge funds are no longer what they are cracked up to be. For most people, the best investment is, and will continue to be, a low-cost index fund. For others, a smaller nest egg, some due diligence, and a bit of luck can result in outperformance - but I feel that few truly possess the knowledge to control their own risk properly - It took me a long time to learn the hard way.

Whether the trends of the last decade continue to exhibit themselves through the next recession will be the test of my thesis. Perhaps another recession is what hedge funds need to make up years of underperformance. However, the statistics show that the S&P has fundamentally changed in its relative statistical performance. The many months of outlier hedge fund performance required to make up the gap are extremely improbable.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.