The Nonsensical Growth of Hedge Funds

Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred-year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut. Cliff Asness

Behavioral economists have provided us with many examples of anomalies in investor behavior, such as a preference for investments with lottery-like distribution despite their very poor historical returns. But the greatest anomaly is that despite decades of poor performance and the failure to effectively hedge exposure to conventional security classes, assets under management among hedge funds have grown from about $300 billion 25 years ago to about $5 trillion today.

The following table provides the returns of the HFRX Global Hedge Fund Index over the one-, 10- and 20-year periods ending December 2022:

Over each of the one-, 10- and 20-year periods, hedge funds destroyed wealth because their returns were below the rates of inflation. Over the last 20 years, hedge funds barely managed to outperform virtually riskless one-year Treasury bills, and they underperformed traditional 60% stock/40% bond portfolios by wide margins. Surely, anyone who foresaw those results would have predicted that assets would flee the industry.

Yet, in a triumph of hype, hope and marketing over wisdom and experience, assets grew dramatically.

Another problem for investors is that the evidence demonstrates that hedge funds, in general, don’t hedge anything.