Do hedge funds serve their purpose?

“…Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.” – SEC, Hedging your bets: a heads up on hedge funds and funds of hedge funds.

“A hedge fund is an actively managed investment fund that seeks attractive absolute return…. Hedge fund managers are active managers seeking absolute return.” – Robert A. Jaegar, All About Hedge Funds (2003)

“Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return, or alpha, for their investors.” – Investopedia

To summarize, the ultimate purpose of hedge fund is to earn attractive return, preferably seeking positive alpha and that’s how the hedge fund managers market their fund – making positive alpha. But are the funds serving this purpose? Do they really make above market returns every year? Have these funds been able to beat the market in the long term, say 5 years, 10 years?

To come up with an answer requires some study since hedge funds are mostly limited partnership and free from all the regulation that mutual funds are subject to, Hence there is limited information about the short/long term performance of the funds.

Morningstar Broad Hedge Fund, which encompasses more than 500 hedge funds serves as a useful index for benchmarking and is also a good estimate of performance of hedge funds. Based on annual return starting 2009 through 2014, the historical rate of return for this index has been 4.3%. At the same time, it has been 10.5% for S&P 500.

Year 2014 2013 2012 2011 2010 2009
MBHF 16.46 20.56 1.77 0.14 6.12 11.77
S&P 500 11.39 29.6 13.49 0 12.78 23.45

(Data extracted from Morningstar)

Even when individual years are compared, hedge funds have been able to beat S&P 500 only 2 out of 6 times. So even though investing in the market seems a viable investment compared to hedge fund, still hedge funds are popular and attract investments from accredited investors. The popularity for hedge funds can be associated to these causes: Gains are announced. Out of the many existing hedge funds, there are few standout firms that are earning substantial returns, sometimes even during market turmoil. These are the funds that get media coverages, thereby garnering attention. On the other side, limited regulatory requirement means limited disclosure of information i.e. no need to publicize losses. A decent bet. Hedge fund are essentially a good lottery to bet on. Since its open only for accredited investors, they won’t feel as much financial pain as would a non-accredited investor. On the up side, you have better chance in winning in a hedge fund than in winning a lottery ticket.

In essence, hedge funds do not serve the purpose they are supposed to serve. However, given the limitation of data, it is necessary to further assess this scenario with sufficient data to support this conclusion.

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Golden formula for investment – it’s a secret!

Is there a formula that can find out whether a security is bullish/bearish thereby generating trade signal of going long or short? Most probably there is! How do I get access to it? You never will. Or even if you do, it will never be the chicken that lays golden eggs.

Why? Efficient market hypothesis – An investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. (Investopedia, n.d.)

Suppose there is an insider information about a company that is exclusively available only to you. What do you do? If the information is positive, you go long and vice versa. Now say that the same information is available to 100 investors. Will you be able to generate same amount of return? NO. Because someone else will bank on it and drive prices up/down, decreasing your return or in some cases you won’t get any return at all because prices already reflect the information.

Same thing goes for an algorithm that you have figured out to generate you returns. If you keep it to yourself, you will earn hefty returns. The moment you leak it out, you are sacrificing your earnings. Or even if you keep it a secret, someone will figure it out as there are plenty of creative brains working day and night trying to figure out on beating the market.

A recent article featured in WSJ talks about how Elements Capital Management LLC is betting on earning handsome returns through arbitrage. If things go as planned, yes it will bring Elements Capital Management and its clients huge return. It might work for other early market entrants looking to follow its footstep. But soon it will become so common that the inefficient becomes the efficient and the arbitrage no longer exist.

Thus if you have the “Golden Formula” that lays golden eggs, keep it a secret. Unless you want to make contribution sacrificing your returns.