Simplicity: The Better Alternative

Today is Friday, so shall we play a fun game? Word association! What do you think of when we say, hedge funds?

If our many encounters and conversations with regular investors are any indication, the most popular answers will be something like: high-returning funds with hot-shot managers; top funds only the mega-rich can own, making them mega-richer; things fast-talking men run in movies; surefire winners; and, probably, scams. A lot of this is because hedge funds have this rarefied appeal from being limited to “accredited investors” only, which basically means being high-net-worth or high-income by 1980s standards (the threshold wasn’t indexed to inflation). But that has changed some. For one, a lack of inflation-adjustment means more and more folks meet asset or income levels to become accredited. But also, a number of funds using tactics traditionally associated with hedge funds have popped up in recent years, selling themselves as alternative mutual funds. Finally, the pitch went, normal folks would have access to all these winning tactics, helping boost returns relative to a stock portfolio or stock/bond blend.

Except, it hasn’t quite worked out that way, at least not according to some nifty research George Mason finance professor Derek Horstmeyer published in The Wall Street Journal this week.^[i] Together with his research assistants, Kurshat Gheni and Heyuan Li, he corralled and categorized all US-listed, dollar-denominated alternative mutual funds. Those categories largely fit with popular hedge fund tactics: “market-neutral, event-driven, macro trading, multistrategy, option-based arbitrage, relative-value arbitrage, systematic trend, global-focused and merger arbitrage.”

To translate that for non-finance-industry types, in order:

• Blending long and short positions into a net market exposure of roughly zero. Meaning, your long positions are about equal to your short positions.
• Trying to capitalize on the market’s potentially wrong reactions to corporate restructuring, mergers, spinoffs and other such “events.”
• Basing positioning on global economic and political trends and forecasts.
• A smorgasbord of all these types of strategies.
• Basically buying put and call options on the same securities or commodities in hopes of exploiting small price inefficiencies.
• Basically buying and selling the same securities or commodities in hopes of exploiting small price inefficiencies.
• Using technical analysis-type rules that amount to following momentum or other trends.
• Basically a global stock portfolio, perhaps with some leverage.
• Playing stock-based mergers by buying the target company and short-selling the acquiring company—or, if they expect the deal to fall through, short-selling the target. Stuff like that.

Anyway, the findings! On average, the study found these funds are low-returning and low-volatility, making them not much different from bonds—and making the diversification benefits questionable, especially when you factor in their relatively higher fees. The exceptions were option-based arbitrage and systematic-trend funds, which had even lower returns and high volatility, which is the opposite of what hedge funds aim to achieve (it is right there in the name, hedging).

The researchers also examined the diversification benefits by looking at the funds’ correlation with the S&P 500. They found the average correlation is 0.70. Now, for those not familiar with the correlation coefficient, it is a statistical measure of the directional relationship between two variables. It ranges from -1.00 to 1.00, with -1.00 meaning the two always move in opposite directions, 0.00 meaning no relationship and 1.00 meaning they always march hand-in-hand. So a 0.70 correlation means stocks and alternative funds move together much more often than not.  If your goal is to add a lower-correlated asset to your overall long-term mix in order to reduce overall volatility, these probably aren’t a good way to do it. And that is before we have even considered the ongoing management fee as well as the entry and exit fees that tend to dominate this space.

We see a valuable lesson here: Just because a given strategy was traditionally available only to certain high-net-worth investors and looks totally bigshot in television and movies doesn’t mean it is actually a value-add for most folks. The simple truth is that hedge funds fail and fold all the time, usually running hot for a few years while their strategy is in favor, then imploding when another trend ascends. In late 2018, an exit stampede from troubled hedge funds nearly spiraled global stocks into a full bear market as they all raced to liquidate positions so they could close shop. The pop culture reputation overstates reality, in our view.

Thankfully, if you are investing for long-term growth, you don’t need expensive flashy tactics. There is this wonderful thing called the stock market that, even with its ups and downs (sometimes big ones) along the way, has delivered marvelous growth over time, generating wealth for the people with the patience and discipline to stick it out. For those who want growth but less volatility along the way—and are willing to sacrifice some return in exchange for that—bonds do an excellent job, overall and on average, of smoothing the ride. There is beauty and democracy in the simplicity of it all.

So if you ever find yourself getting hedge fund FOMO, remember this study and take a deep breath. If you are diversified within stocks (and bonds) and patient through volatility, you will likely find yourself in a much better financial position in the long run than if you start dabbling in newfangled, jargon-rich alternatives.