Hedge Funds Don’t Beat the Market – Is This a Bad Thing?

A common criticism of hedge funds is that they don’t beat the market (commonly taken as the S&P 500).

Some even use this as a way to question why they exist in the first place.

But… Hedge funds as a whole shouldn’t be expected to beat the S&P.

Alpha is a zero-sum game. If you deviate from the index in some way, then you’re making a bet that you’re right and somebody else is wrong.

Moreover, there are transaction costs and other fees that turn this into a negative-sum game.

So naturally, their performance will always lag the market to some degree. It’s simply in-built into the market structure.

The argument is like saying sports coaches as a whole don’t have a winning record. Does that mean we just shouldn’t have coaches?

It’s self-evident why they don’t have winning records as a whole – they can’t.

Winning is a zero-sum game, so they can’t collectively produce a winning record. Yet there are a select few coaches (like investment firms) who are consistently better than others.

There are a group of hedge funds that are consistently very good. And there are many that have no real edge as it pertains to whatever markets or form of business they engage in relative to a representative benchmark.

The problems with comparisons

If an LP goes to a hedge fund and tells them they want 5 percent above inflation annually at 12 percent volatility (less than the S&P 500), and they consistently deliver on that promise – is it bad that they’re doing exactly what they said they would do even if the S&P is above that performance over recent market history?

One big component of returns is risk.

If a firm is taking less risk in their investment style it’s likely they’ll underperform a strategy taking higher risk, even if their reward-to-risk (i.e., risk-adjusted returns) is superior.

The problem with the S&P as a benchmark

There’s also a problem with using the S&P as a benchmark, especially for firms that are not a long-only equities fund (like a mutual fund).

For example, if the S&P is down 30 percent and a hedge fund (or any type of trader) is down “only” 20 percent, is that great performance?

They might be beating the index by a wide margin but the performance is still objectively horrible.

And if the S&P is up 30 percent and you’re “only” up 20 percent, is that “bad” performance?

That’s very good performance irrespective of what the benchmark is doing.

Likewise, if you’re a landlord, you probably don’t care how your returns (e.g., net operating income divided by total cash invested into the properties) compare to the S&P 500.

You’re just trying to get what you can get and it’s not really appropriate to compare your performance to the stock market.

Basically all businesses are “absolute return” vehicles.

Hedge funds and differentiated returns streams

Moreover, having differentiated returns is a big component of alternative investment vehicles.

The average equities-focused hedge fund (and most hedge funds tend to focus on stocks) has a 0.70 or higher correlation with the stock market. This is very high for a returns stream that is supposed to be different.

 

Lack of differentiation and high correlation with other asset classes tends to be a bigger problem

hedge fund correlation, hedge funds don't beat the market, Lack of differentiation and high correlation with other asset classes tends to be a bigger problem

(Source: MSCI)

 

If you go to a hedge fund and it’s almost the same thing as what you could get with a basic ETF – which is basically free – it largely defeats the purpose. It’s hard to create alpha in the stock market, as it’s one of the most competitive markets out there.

Those who turn to hedge funds – e.g., pension funds, endowments, foundations, sovereign wealth funds, accredited investors – look toward them for a returns stream that isn’t correlated with their other investments or could even be a risk-off hedge.

Therefore, you’re not necessarily looking for S&P returns. You’re looking for a positive returns stream that’s truly differentiated in some way.

 

Final word

Hedge funds don’t beat the market, but they shouldn’t be expected to, given alpha is zero-sum and there are fees associated with doing business.

Hedge funds are fundamentally absolute return vehicles, not relative return vehicles, like a mutual fund might be.

In the end, there is real value to investment firms, whatever label or designation one wants to slap on them. Capital allocation is a very important part of an economy.

Bank, nonbanks, local governments, central governments, private nonfinancial companies, individuals, and so on, all have a role to play in this process.

 

 

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