Key Takeaways
- • Hedge funds returned only 3% in 2014 versus 11% for the S&P 500 Index, a substantial underperformance that persists despite continued investor inflows and $2.85 trillion in assets under management.
- • Hedge fund performance data significantly overstates true industry returns due to survivorship bias and voluntary reporting; funds with poor results are not obligated to disclose performance, creating an absence-of-poor-performers bias in widely cited indexes like those from HFR.
- • Even low-cost 60/40 balanced mutual funds (stocks and bonds) have outperformed the average hedge fund, undermining the argument that hedge fund underperformance stems from their hedged strategy rather than fundamental structural issues.
- • Despite chronic underperformance, investors continue allocating capital to hedge funds, suggesting a disconnect between fund returns and capital attraction—a paradox that raises questions about investor decision-making, fee structures, and market dynamics.
Summary
The hedge fund industry faces a fundamental paradox: despite significant underperformance relative to both equity indexes and simpler alternatives, assets continue to flow into the sector. According to data cited by Greg Zuckerman of the Wall Street Journal, the average hedge fund gained only 3% in 2014, compared to an 11-percentage-point gain in the S&P 500 Index. This performance gap is particularly stark given that hedge funds charge investors 2% management fees plus 20% of profits—fee structures that are difficult to justify against benchmark returns.
The underperformance extends beyond equity index comparisons. A simple 60/40 portfolio combining stocks and bonds has outpaced average hedge fund returns, suggesting that the poor relative performance cannot be attributed to a hedged investment approach alone. This raises questions about the value proposition of hedge funds as a distinct asset class, particularly when investors can access diversified portfolios through lower-cost mutual funds.
Critical to understanding reported hedge fund performance is recognizing significant measurement biases. Simon Lack's analysis in "Hedge Fund Mirage" highlights that widely cited indexes from firms such as HFR substantially overstate industry returns. Hedge funds are not required to report performance data—disclosure is entirely voluntary. Consequently, indexes exclude underperforming funds that have chosen not to report, creating a survivorship bias problem. Additionally, funds that have closed due to poor results disappear from historical indexes entirely. The true performance of the hedge fund industry, when accounting for these methodological gaps, likely falls well below the reported 3% annual figure and the approximately 7% average annual return since 2009.
Despite these challenges and the disconnect between fund performance and investor returns relative to fees, the industry has attracted $2.85 trillion in assets under management. This phenomenon—strong capital inflows accompanying weak performance—represents one of finance's most enduring puzzles and suggests that factors beyond raw performance drive investor allocation decisions in the hedge fund space.
The underperformance extends beyond equity index comparisons. A simple 60/40 portfolio combining stocks and bonds has outpaced average hedge fund returns, suggesting that the poor relative performance cannot be attributed to a hedged investment approach alone. This raises questions about the value proposition of hedge funds as a distinct asset class, particularly when investors can access diversified portfolios through lower-cost mutual funds.
Critical to understanding reported hedge fund performance is recognizing significant measurement biases. Simon Lack's analysis in "Hedge Fund Mirage" highlights that widely cited indexes from firms such as HFR substantially overstate industry returns. Hedge funds are not required to report performance data—disclosure is entirely voluntary. Consequently, indexes exclude underperforming funds that have chosen not to report, creating a survivorship bias problem. Additionally, funds that have closed due to poor results disappear from historical indexes entirely. The true performance of the hedge fund industry, when accounting for these methodological gaps, likely falls well below the reported 3% annual figure and the approximately 7% average annual return since 2009.
Despite these challenges and the disconnect between fund performance and investor returns relative to fees, the industry has attracted $2.85 trillion in assets under management. This phenomenon—strong capital inflows accompanying weak performance—represents one of finance's most enduring puzzles and suggests that factors beyond raw performance drive investor allocation decisions in the hedge fund space.
Go deeper than the headline
Research every firm in this story, track the ones that matter and get the daily briefing — free for 7 days.