The California Public Employees’ Retirement System, the second largest pension fund in America, recently decided to divest its entire $4 billion from hedge funds after spending $135 million in fees for only a 7.1% gain in 2013.
There are two shocking statistics here: 1) $135 million in fees on $4 billion AUM = 3.4% and 2) The S&P 500 returned 32% and outperformed CalPERS’ hedge fund performance by an astonishing 25%.
Such drastic costs for such poor performance really underscores the futility in trying to outperform the index. Hedge fund managers are supposedly some of the brightest minds on Wall Street. But it’s safe to say that paying outsized fees for mediocre performance is not a great way to build wealth. In defense of hedge funds, hedge fund performance should underperform the S&P 500 during a bull market by nature of its hedging strategy. But hedge funds faired no better during the financial crisis either.
If you want to invest in a hedge-fund and don’t have the $1 million dollar typical buy-in fee (probably much lower for the really underperforming ones), you could buy the hedge fund ETF, HDG, which tracks a basket of the largest hedge funds in the world. But since HDG’s formation in late 2012, the index has done nothing but underperform the S&P 500 index (blue line).
It’s much better to work for a hedge fund and earn the typical 2% AUM fee plus 20% of profits, than invest in a hedge fund. Once you get to a large enough size, a good strategy as a hedge fund manager is to simply go market neutral or hug the index so that performance is never too out of line. A 2% fee on $1 billion AUM is still $20 million a year even if you provide 0% return. Now imagine if you grow your hedge fund’s size to $10 billion or more. Lamborghinis for all!
Focus on asset allocation based on your individual risk tolerance rather than trying to beat the market. There are more fun and rewarding things to do with your time.