Initial numbers suggest that the first half of 2019 was the best six months on record for the hedge fund industry since 2009. In many ways, it isn't surprising that hedge fund managers achieved such a strong positive performance during the first half of this year. The S&P 500 index rebounded by nearly 20% between January and the end of June 2019, and a rising tide lifts all boats.
Unfortunately, while most hedge funds did achieve a robust positive performance during the first six months of the year, they failed to match the index's strong return.
The S&P 500 rose 17% between January and the end of June but, on average, hedge funds have gained 7.06% in the first half of the year -- a sizeable gap. Some funds have performed dramatically better, however, notching up gains of 40% or more though, for the most part, the industry has failed to match the S&P 500.
Reading through the performance of not just hedge fund managers but private investors and mutual fund managers as well, it seems that most active managers are underperforming in this environment. This has led me to ask the question: Should we really be concerning ourselves with S&P 500 returns as investors?
Is the S&P 500 a good benchmark?
There's really no clear-cut answer to this question. We know that over the past 100 years, the S&P 500 has produced an average annual return between 7% and 9%, and on this basis, the index's performance during the first half of 2019 is excessive.
Is it sensible to try to chase the performance of an indicator when we know it is double its historical average?
We also know that the index is trading at a level of valuation that has, historically, proven to be expensive. So, should we be paying a premium multiple for a premium asset just because we want to match its returns?
As a student of Warren Buffett (Trades, Portfolio) and value investing, I'm well aware of just how volatile leading market indicators can be in the short term and, therefore, I'm skeptical that benchmarking against the S&P 500 or any large-cap peers for that matter, is of any use. Instead, my reading has led me to the conclusion that positive returns throughout the market cycle are a better indicator of performance than market chasing.
The billionaire value Seth Klarman (Trades, Portfolio) believes that risk should always be the first point of analysis for investors, and as long as you are controlling for risk and eliminating it from your portfolio, then the returns will come over the long term. I subscribe to this viewpoint. While my performance might not be able to match the S&P 500 in the short term, my focus is on controlling for risk and achieving positive returns throughout the market cycle.
The right benchmark
As I stated above, trying to decide which is the best benchmark for you is not an easy process. By controlling for risk, I may be missing out on some of the best opportunities the market has to offer, but it is an approach that suits me and my investing style. The other factor to consider here is risk tolerance. The easiest way to match the performance of the S&P 500 is just to track the index, but this has other problems. If the market were to fall 50% tomorrow, you would lose 50% of your money.
I find this unpalatable because I do not know what's around the corner in life, and don't want to be in a situation where I have to sell at the bottom of the market. Asset allocation is just as important as investment selection and being pushed into making an investment mistake by the market is something we should seek to avoid as investors at all costs.
The bottom line
The idea of benchmarking is something all investors should consider because it gives us some idea of how we are performing compared to the rest of the market, but it also helps focus our attention on what matters. Using an inappropriate benchmark can push you to make inappropriate investment decisions and can be psychologically damaging. This is something to consider in the current market environment.
Disclosure: The author has no share mentioned.
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