The poor performance of the hedge funds industry last year as well as in the last 10 years has prompted many to question their very existence. Are they really worth it?

Hedge funds have had a miserable 2012 as they returned just 3% to the investors. By contrast, the S&P 500 index was up 18% during the year. In other words, you would have been better off just investing in the stock market index and tending to your garden. So much for hedge funds generating ‘alpha’ – excess over the market returns. Indeed, they have failed, again and again. Hedge fund managers with degrees from prestigious universities such as Harvard, MIT, Stanford, etc, and with years of experience in financial markets have simply failed to exploit gaps and take advantage of the favourable market conditions.
 

However, if you thought 2012 was just an unlucky year for hedge funds, think again. What is more startling, however, is the fact that S&P 500 index has outperformed hedge funds in the last 10 straight years, except for 2008—the year Lehman Brothers went bust. Worse still, according to Goldman Sach’s David Kostin, a whopping 88% of the hedge funds underperformed the market last year alone. This is by no means a small number, given that majority of them are presumably smart. How come these smart hedge fund managers couldn’t ride on the market’s coattails which went up 18%?
 

Check our previous pieces on hedge funds over here: The myth of hedge fund prowess:  and Not much of an alternative:
 

Even big name hedge fund managers fared poorly. For example, John Paulson, who famously made $1 billion shorting the housing boom in America, too, lost money. According to The Economist, he lost 17% in the first ten months of 2012, after a 51% fall in 2011. According to Reuters, David Einhorn’s Greenlight Capital lagged S&P 500 and gained only 3.17%. Einhorn rose to fame after famously calling Lehman’s bluff and predicted it would be bankrupt. Among Einhorn’s great recent ideas was Apple at nearly $700 while the price now is below $500, at around $458.
 

The irony is that the Federal Reserve, America’s central bank, had created conditions so ideal for market participants to thrive. After all, the bank bailouts of 2008 made hedge funds supremely wealthy and the market went up. The successive quantitative easing and loose monetary policy meant that financial institutions, banks, and especially hedge funds had more money to play around with. The quantitative easing also artificially propped up various markets. It is also pertinent to note that hedge funds usually had access to the highest echelons of the government and privy to information that mutual fund and retail investors did not have.
 

How come hedge funds lost money? One explanation is that while it is true that hedge funds had more money to play around with, they simply had to play the same game, namely the long game, with other investors, mutual funds and retail investors. In other words, they couldn’t go short when they wanted to because the central bank had virtually eliminated downside risks by printing more dollars. Hedge funds were created to go long AND short and everything else in between, unlike mutual funds and retail investors who normally go long.
 

Another explanation is their sheer big size. The industry size ballooned four times since 2000 and now manages over $2 trillion in assets, an astounding figure. This is where the laws of diminishing returns would probably kick in—too much cash chasing too few strategies, which means taking investment bets that lack the real ‘edge’. Simon Lack, a hedge fund critic, was found quoting in The Economist saying, “At $1 trillion of assets under management hedge funds delivered acceptable returns. Less so at $2 trillion.”
 

The inability to have an ‘edge’ over others, especially old-fashioned retail stock pickers, has endangered the very existence of hedge funds. According to Bloomberg Markets, 635 hedge funds shut shop last year due to poor returns and mass redemptions, 8.5% more than in 2011.
 

Another impediment to generating high returns is high fees with the added pressure to outperform the markets year after year. In fact, a study had shown that the smartest investors are the ones who invest in low-cost funds. We had written this in our 7 February issue of Moneylife in our Earning Curve section (this issue is currently on stands).
 

This doesn’t mean that every hedge fund is endangered. Indeed, there are a few who spot the gaps in the market and exploit it exceedingly well. For instance, last year, Dan Loeb’s Third Point Ultra Fund generated 33.6% returns after fees. And there’s Steve Cohen’s SAC which made 12% returns (still this is below the S&P 500 index) although Cohen is suspected to have benefited from insider trading. However, such funds are few and far between and spotting winning hedge fund managers beforehand is almost impossible.

Read our review of The Quest for Alpha which pulls together various studies to show how hedge funds, venture capital, private equity etc. by and large generate sub-par returns, after adjusting for risks.
 

So what should the retail investor do? According to The Economist, a simple investment portfolio—60% in shares and the rest in sovereign bonds—has delivered returns of more than 90% over the past decade, compared with a meagre 17% after fees for hedge funds. In other words, a simple portfolio consisting of diversified equities should do the trick. If not, at least investing in diversified equity mutual funds over the long-term is also a time-tested strategy. Or you could simply invest in an index fund, SIP method and relax.

Here are some useful links that we have written about investing the sensible way.

15 stocks with high dividend yield

SIP smartly