Why 90% of Hedge Funds Underperform the S&P 500

When someone thinks of an investor their mind might immediately drift to the idea of a hedge fund manager, a wealthy investor managing billions of dollars and securing every single basis point return possible for their clients. What if I told you that investing in the S&P 500 index, one of the simplest index funds taught to every amateur investor, would actually return higher than 90% of hedge funds, this is an even higher percentage in 2021. This is of course before the funds’ standard 2 and 20 fees. This refers to a 2% fee on total AUM and a 20% fee on all returns after passing a set hurdle. How could this happen if hedge funds have hundreds, some with thousands of investors to manage money as efficiently as possible for their large clients.

Large AUM

Many large funds have billions of dollars they must manage for their clients. This means that it takes days, sometimes weeks to open and close positions by which time potential gains could have been wiped out. Over time, this artificial tax eats at fund returns until they are nearly nonexistent. This limitation ironically creates a fairer playing field for smaller funds that have less talent, however for investors, this is not a good outcome. Many of these investors include pension funds that manage retirement savings for millions of people. If hedge funds have too much capital to divest properly, maybe they are not the right investment for large funds that can afford other alternative ventures.

Risk Management

The core tenet of investing is risk management. With billions of dollars, hedge funds have an obligation to their investors to make sure that they don’t lose their money. This is even more important than gains. To do this funds have to keep their relative position sizes small. This hurts funds as they must have a lot of winners just to average out their portfolio gains. Risk management becomes much harder when combined with enormous position sizes.

Should People Still Invest in Hedge Funds

Obviously, hedge funds have it much harder than mutual funds that follow indices. However, with these problems comes more opportunities. Hedge funds can trade a variety of financial instruments that are inaccessible to most other investors. In addition, many hedge funds attract some of the best-qualified investors in the world. With all of these advantages, many of the disadvantages are outweighed. Hedge funds should still operate as they have the power to garner returns. However, as the past few years have been tough on the industry many investors will likely allocate their capital to other assett classes such as private equity and venture capital.