PETER DOLEZAL: Forget the envy: be thankful you missed out on hedge funds

Performance figures of hedge funds also tend to be overstated.

Have you envied your well-heeled friends’ hedge fund holdings — wishing that you too had a portfolio large enough to participate in this exclusive and narrow investment opportunity?

Forget the envy. Be thankful that you missed out on investing in this product.

Hedge funds are sold as somewhat exotic investments which not only claim to outperform more traditional investments, but also to reduce downside volatility in times of major market corrections. These funds typically charge a two per cent annual fee, plus a performance fee of 20 per cent on any upside value growth — making them even more expensive than the 2.4 per cent average MER of Canadian mutual funds.

Are the results worth the high cost?

Using data provided by Hedge Fund Research Inc., the average global hedge fund delivered, in the 12 years between January 2003 and September 2015, a compounding annual return of 0.94 per cent. By contrast during the same period, the U.S. “Couch Potato” portfolio of Index funds delivered an annual average total return of 6.3 per cent.

Closer to home, the Bank of Nova Scotia’s Canadian Hedge Fund Index shows that while Canadian hedge funds performed better than their global counterparts, they still fell significantly short of the performance of the CDN “Couch Potato” index-based portfolio.

The comparison “Couch Potato” portfolio consisted of four equal parts: a CDN bond index; a CDN stock index; a U.S. stock index; and an International stock index. In the 10 years since 2005, the CDN globally-oriented hedge funds averaged a total annual return to investors of 4.38 per cent, compared to 6.7 per cent for the “Couch Potato” portfolio.

Interestingly, the hedge funds’ total-return shortfall was approximately equal to the difference in fees charged.

Performance figures of hedge funds also tend to be overstated.

Like mutual funds, many exit the market place. The number of disappearing funds is not insignificant. A Princeton University study concluded that between 1996 and 2004, about 75 per cent of hedge funds went out of business. The performance of the terminated funds is, conveniently, not included in the published results of the hedge fund sector.

Hedge funds world-wide still comprise only about five per cent of all invested capital. With long-term comparative results such as these, one would think hedge funds would have difficulty maintaining, let alone increasing, their future market share.

What about hedge funds claims that they better protect the investor in a severely- falling market? Performance comparisons during declining markets in the past 10 years demonstrates that the “Couch Potato” portfolio outperformed comparable hedge funds.

What is the lesson in this? It reaffirms that much of the financial services industry bases its claims on the “illusion” of value it sells to an uninformed public — including a significant number of wealthy hedge fund investors.

It also affirms the lower an investor’s annual holding cost, the greater the likelihood of at least matching market performance.

Chasing better-than-market performance rarely succeeds.

 

A retired corporate executive, enjoying post-retirement as an independent Financial Consultant (www.dolezalconsultants.ca), Peter Dolezal is the author of three books, including his most recent, The SMART CANADIAN WEALTH-BUILDER.