Hedge funds are frequently attacked for having high management and performance fees. They are criticized for achieving poor returns for investors while charging hefty price tags. As a result, some analysts argue that investors should choose passive tracker funds instead.
While most individual investors will probably never get the chance to invest in a hedge fund (even for the smaller funds, the minimum investment sits around $100,000), I believe it would be a mistake to ignore what the industry is doing. Indeed, I think it is essential to acknowledge that the hedge fund industry's dispersion in returns and fees is incredibly broad.
Yes, some hedge funds have failed to outperform over the past couple of decades, and they have charged investors a lot for this lack of performance. However, some hedge funds have achieved outstanding performance, and these funds are worth their management fees.
Performance gap
Studying the difference between well-performing and poorly-performing hedge funds can throw up some interesting points. Many hedge funds underperform because they charge so much in management fees. Investors should consider this when analyzing other fund investments, but fees are not everything. This is another point to consider. It may be worth paying higher fees if one wants to build exposure to a different asset class or if the fund in question has a track record of outperformance.
I believe it is also worth paying attention to hedge fund actions because research shows that these funds are better investors than individuals in the long term. Indeed, research shows that the average retail investor has earned 2% to 4% on their portfolios over the past three or four decades. Meanwhile, the average hedge fund return is around 5%.
To put it another way, while the hedge fund industry might have come under pressure for its lack of performance compared to tracker funds, hedge funds have actually outperformed retail investors on the whole.
Why do investors underperform?
We have to ask ourselves why many hedge funds and retail investors underperform in order to get a clear picture of what we can learn from the industry. One of the main reasons behind underperformance is overtrading. Investors are unwilling or unable to hold investments and do nothing. They would rather trade in and out of positions in an attempt to beat the market.
Hedge funds follow the same approach, but they are usually the first in and the first out. Retail investors are generally the last to hear about any corporate news or economic releases. As such, retail investors do not have the first-news edge that hedge funds do.
By understanding why hedge funds perform in the way they do, we can build an understanding of what the average investor should not do. Hedge funds try to time the market, as they have more data and can move faster. The everyday investor is at a disadvantage here.
The bottom line
The conclusion one should draw from this is the fact that it might be better to stay away from this arena type of investing when one has no edge. Hedge funds have more data and brainpower to analyze companies. This gives them an edge in finding undervalued securities, especially in areas such as the small-cap market, compared to the individual investor.
However, where the individual investor has the edge is time. Hedge funds are consistently chasing quarterly performance figures. This means they cannot buy and hold securities if these securities are not producing attractive returns in a short timeframe. The individual investor can hold stocks indefinitely, even if they suffer a period of underperformance.
With this being the case, it looks as if many investors are giving away the only edge they have over Wall Street, the ability to buy and hold securities indefinitely, if they try and follow hedge funds directly. Of course, this is not a guaranteed strategy for outperformance, but it is something to consider.
