Smartest investors have also failed


Investors started getting excited about hedge funds in the 1990s, when people like George Soros and Steve Cohen were earning returns of 30 percent or more, year after year, crushing the market.

More funds opened, and their marketing pitch went something like this: We have the best investors in the world, and their returns are not correlated to the rest of the market. We will earn you so much money that we deserve the absurd fees we’re going to charge you for it.

This worked for some funds for some time, but it’s become plainly clear in recent years that the biggest bull market was in inflated promises. As a group, hedge funds -- which now manage $2.5 trillion -- have consistently underperformed a basic S&P 500 index fund over the last five years.

Now a new hedge fund marketing pitch has been born, one I’ve seen over and over again. It goes like this: Sure, hedge fund managers say, maybe we don’t outperform the S&P 500. But that was never our goal. Our goal is to manage risk, offering limited upside while protecting investors’ downside with lower volatility than the rest of the market.

But if a hedge fund’s goal is to manage downside risk, it shouldn’t be compared to the S&P 500 at all. It should be compared to a benchmark that also tries to manage downside risk, like a simple index that invests 60 percent of its assets in stocks and 40 percent in bonds.

Vanguard has a 60/40 index fund with a super-low expense ratio of 0.24 percent. Its returns over the last decade compared to the returns of the average long-short and multistrategy hedge fund?

The 60/40 Vanguard fund -- which anyone can invest in, opening an account in about four minutes and 26 mouse clicks (I counted) -- beat the average multistrategy and long-short hedge fund over the last decade. And it did it with lower annual volatility (measured by standard deviation).

Put it all together

Hedge funds’ selling point used to be superior returns. But that went away.

Now their selling point is protecting downside risk. But they don’t do that any better than a 60/40 index fund, either.

The results are actually worse than I’m showing here, because the hedge fund returns in this chart are from an index comprising hundreds of funds, which no one can actually invest in. The actual experience of investors in individual hedge funds is more volatile than this chart shows, with some funds doing better and others much worse.

By almost any metric, the average hedge fund investor would have been better off in Vanguard’s 60/40 fund over the last decade.

Maybe the future will look different. You don’t need to be too imaginative to picture a world where both stocks and bonds do poorly, which could end the 60/40 portfolio’s outperformance over hedge funds. But that’s hypothetical. Hedge funds’ fees, and their underperformance, are very real, here and now.

Be careful when worshiping the "smart money."

The average investor is incredibly boring.

Have you heard about the "great rotation"? It’s the theory that after pulling money out of stock mutual funds and dumping it into bond funds for the last six years, investors are about to change direction, yanking money out of bonds and sending it into stocks.

It’s already happening. According to the Securities Industry and Financial Markets Association, investors pulled $554 billion out of stock mutual funds between 2008 and 2012 and put more than $1 trillion into bond funds. But in the last year, $158 billion has gone into stock funds, and $58 billion has been pulled out of bonds.

The great rotation

But dig into the numbers and you’ll see there’s nothing great at all about what’s happening. Withdrawals of $100 billion or $500 billion might sound enormous, but you have to remember that Americans today own $14.3 trillion worth of mutual funds.

When you put the great rotation into context of the size of the market, it’s barely a drip. We’re talking about moves in the low single percentage points. It’s tiny. And a lot of the money pulled out of stock mutual funds went into stock ETFs, so the moves were actually smaller. There’s more action in bond funds, but it’s still pretty small.

When you see the headline "Investors plow $125 billion into bond funds," it sounds extreme. If you saw the headline "Investors increase their exposure to bonds by 4.3 percent," you wouldn’t bat an eye. They’re basically saying the same thing, but the latter is in better context.

In markets, prices are set at the margin, meaning the price you see on your screen just represents the last trade made, even if it was a single share. I think there’s a tendency to assume that when the market is crashing, everyone is running for the exits. But that’s almost never the case. The huge majority of American investors add a little bit to their investments each month through their 401(k), and then just forget about it. The day-to-day, even year-to-year, action in markets is directed by a very small percentage of investors.

A note from the past

Here’s what I wrote a few years ago, when the S&P 500 fell nearly 20 percent in 2011:

"At the Vanguard Group, 98 percent of investors didn’t make a single change to their retirement portfolios in August, when market volatility peaked. ‘Ninety-eight percent took the long-term view,’ wrote Steve Utkus, who oversees the Vanguard Center for Retirement Research. ‘Those trading are a very small subset of investors.’

"Even during longer periods when markets underwent gut-wrenching drops, the percentage of Vanguard investors who called it quits was incredibly small. ‘We know from our research that during a financial crisis, few investors actually cash out their entire portfolios,’ Utkus wrote. ‘Yes, there is always a small fraction of investors -- 3 percent in the recent financial crisis -- who sell everything, so there’s always someone to interview about getting out of the market. But they aren’t typical investors.’"

When the headlines portray everyone freaking out, most people are actually pretty calm.


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