Another year of hedge funds not earning their keep

A typical hedge fund requires that any interested buyer first meet the definition of an "accredited investor." That usually means a person who earns at least $250,000 per year or has net worth of at least $5 million.

If you have ever thought about investing in a hedge fund, perhaps you considered that threshold unreasonable. These days, it's something to be thankful for.

The performance of hedge funds has been especially poor in recent years, making it more difficult than ever to justify the cost and restrictions they demand of investors.

According to data compiled by financial analytics company eVestment, hedge funds as a category returned 8.9% in 2017 compared to a 21.8% return for the S&P 500.

Many will argue it's not appropriate to measure hedge funds directly against equities. Fine. A basket of 50% global equities and 50% bonds gained 14.8% in 2017, still well above the Hedge Fund Aggregate.

Hedge funds, we are often told, reveal their true worth during periods of market weakness and high volatility. Well, the S&P 500 lost 4.4% in 2018, which included an especially sharp decline of almost 20% late in the year. The 50/50 basket of global stocks and bonds fell 4.6% in 2018. Hedge funds, as a category, lost even more (-5.1%).

Year-to-date numbers show a continuation of the same trend.

As you might expect, their investors have noticed. Through the first three quarters of 2019, hedge funds saw net outflows of $77 billion and have experienced six consecutive quarters of outflows overall.

It's fair, of course, to expect periods of underperformance with any actively managed strategy. But consistently weak returns three years in a row are tough to swallow, especially when the major equity benchmarks have soared to all-time highs.

This isn't, by the way, meant as an advertisement for passive index investing. There is value to be found in the right actively managed strategies, and risk management (losing less during down markets) is a vital component in helping most people maximize long-term returns.

But why pay close to 2% per year plus incentive fees for that chance? Not to mention limited access to your money (think: quarterly liquidity), K-1 tax reporting likely to require filing an extension, and a real lack of transparency regarding how the dollars are actually invested. Many private-equity strategies — a "cousin" of hedge funds subject to similar constraints — include capital calls, which contractually obligate you to invest more money into their strategy whenever the manager requests it, regardless of previous performance.

Hedge funds have always been a slice of the investment spectrum tailored to the most affluent. They are marketed, and sometimes desired, for their exclusivity.

Exclusive is meant to suggest "better." The catch is that "better" more likely describes the compensation of the salesmen and companies offering these products.

So, what's the true value to be found among hedge funds?

A modicum of added diversification. Brochures and product descriptions will highlight studies showing a portfolio that includes hedge funds displays slightly less volatility and (perhaps) slightly better returns than a similar portfolio comprised only of stocks, bonds, and cash.

The difference, however, is typically minor and it would be interesting to ask the person handing out those brochures how much data (if any) from the last three years are included in those conclusions.

As in any asset class, there are a handful of exceptions to the rule. Managers who can boast long-term records of outperformance, higher risk-adjusted returns, and legitimately unique investment approaches.

It's also worth mentioning that many hedge funds are not subject to the same degree of rigorous regulatory oversight most investors expect (and deserve) to protect their money.

So, if your invitation to join the hedge fund investors club got lost in the mail, there's no need to feel left out. If, on the other hand, your investment portfolio already includes hedge funds, it might be time to ask again about the liquidity schedule.