Monday, November 26, 2012

Hedge Fund Futility: Why bother?

A recent study by Goldman Sachs highlights the futility of hedge funds.  

Returns through November:
S&P 500 Index 14%
Average Large Cap Mutual Fund 13%
Average Hedge Fund 6%

In other words, index funds have beaten most mutual funds and crushed most hedge funds.  One of the reasons for poor performance from hedge funds is their fee structures.  Many hedge fund fees are 2% per year plus 20% of all profits.  

Consider this example:
A lucky hedge fund manager beats the S&P 500 Index by 3% this year for a return of 17% BEFORE fees (Given the efficiency of the stock market, this would be a monumental achievement).  2% would come off the top leaving a 15% return.  But, the 20% take of the remaining profits would eat another 3%.  This would leave the investor with a net return of 12%, which would have trailed most mutual funds and all S&P 500 Index funds.  

My advice:

Stay away from ALL hedge funds.  There is not a single hedge fund out there worth their enormous fees.  Of course, there are some folks out there that would disagree with my advice. 

For example, the North Carolina Retirement System (NCRS) is in the process of doubling their investments in hedge funds from roughly $2.5 Billion to $5 Billion.   I can only assume the person behind this decision is bad at math?  These large investments in hedge funds are part of the reason why NCRS reported a return 13.96% that trailed the average public pension return of 16.68% for the 1-year period ending 9/30/2012 according to the Wilshire Trust Universe Comparison Service (TUCS).  

1-year returns ending 9/30/2012:
simple 60/40 stock/bond index = 20.00%
Average Public Pension Fund = 16.68%
North Carolina Retirement System = 13.96%

To put that into perspective, the NCRS annual underperformance of -2.72% on the $77.1 billion pension plan, cost North Carolina tax payers $2.1 billion this year vs. the average public pension fund.  Of course, the $2.1 billion is the cost to North Carolina if we merely attained the average return for public pensions.  The TUCS report also points out that a simple 60/40 mix of stock and bond index funds returned 20.00% for the same 1-year period.  Thus, the full cost of underperformance of the NCRS vs. simple index funds is 6.04% or roughly $4.6 billion.

To put the annual cost of $4.6 billion due to underperformance of the NCRS pension fund into perspective, the entire state of North Carolina spent $7.5 billion on K-12 education last year.  Another way to look at it, based on a population of 9.5 million, your share of last year's $4.6 billion underperformance is $485 for every man, woman, and child in North Carolina or $1,940 for a family of four.

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