2014 was not a great year for hedge funds as a whole. HFRI reported today that the HFRI Composite Index gained just 3.57% for the year. That was well below the S&P 500’s return of 13.46% and the 4 Fund Global Financial Asset Portfolio’s return of 5.85%. Actually, if we assume a fee structure of 2 & 20 then hedge funds essentially matched the GFAP, but charged their customers about 40% of the total return.
The risk adjusted figures weren’t much better. With a Sharpe ratio of 0.49 the Composite Index underperformed the GFAP (1.8) on a risk adjusted basis.
Of course, the data has been much stronger over longer periods of time. Many hedge funds have generally performed well and have provided a degree of strategic diversification that can’t be found in many low fee index funds. But that’s changed since the early 2000’s and the battle is becoming increasingly difficult for hedge funds as a whole.
As I’ve noted in the past, we’re entering a world where low aggregate returns are likely and that means that precision in asset picking will be the key to generating outsized gains. If I am right that returns could be about 5.5% going forward and you’re charging 2 & 20 then this becomes a losing battle. You can only take 40% of the annual gains for so long before your customers force you to substantially reduce your fees or the industry shrinks. My guess is that much lower fee strategic diversification is where this industry is headed and it’s headed there faster than many like think.
Source: Hedge Fund Research
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.