Hedge funds versus ETFs

by: David Jackson

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.