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A 2005 file photo of John Paulson. (© Reuters Photographer / Reuters/REUTERS/ Chip East)
A 2005 file photo of John Paulson. (© Reuters Photographer / Reuters/REUTERS/ Chip East)

Strategy Lab

Think you’re smarter than a hedge fund manager? Add to ...

Andrew Hallam is the index investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

In the Globe and Mail’s Strategy Lab investment competition, the indexed portfolio I created last September is in last place. My colleagues Norm Rothery, Chris Umiastowksi and John Heinzl are three hares that have left me – the indexed tortoise – far behind.

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Does this mean you should abandon an indexed strategy in favour of individual stocks? Not necessarily. Because of their low costs, passive strategies (such as mine) are relentless pursuers. And with patience, they can beat the returns of most professional investors. Let me prove it.

The Global HFRX index tracks the collected returns of the world’s hedge funds. Reserved for accredited, high net worth investors, they’re considered elite. And they’re run by some of the smartest (and highest paid) money managers on the planet.

Most of these managers, however, that beat the market over the short term, eventually succumb to the index.

The original couch potato portfolio was created by Scott Burns in 1991. Rebalanced once a year, it comprises half of its assets in the Vanguard U.S. Total Stock Market Index with the other half in Vanguard’s Inflation-Protected Securities Index. It’s a simple, unsophisticated combination of stocks and bonds, with expenses charging just 0.19 per cent a year.

Measured in U.S. dollars, it averaged 7.17 per cent for the decade ending 2012. A $10,000 investment, ten years ago, would have grown to $19,973.

In contrast, the typical hedge fund (measured by the HFRX hedge fund index) averaged just 1.6 per cent each year. It would have turned $10,000 into just $11,767. And this is viewing their results with rose coloured glasses. Reported hedge fund results are actually overstated because they aren’t regulated by the Securities and Exchange Commission. As such, fund companies can choose to report their results when they’re good–generating more interest for the firm. And they can discontinue reporting when they’ve done poorly.

Hedge fund managers have the leeway to invest in whatever combination of asset classes they deem fit. If they think the markets will tank, they can short the market by betting against it. If they think gold, foreign stocks or real estate investment trusts will soar, they can load up on those. Despite their sophisticated trading platforms, however, the original couch potato portfolio has beaten the average hedge fund ten years in a row.

If you’re clinging to the notion that you can outperform most hedge fund managers with your own stock picks – because of the fees they charge – you may want to reconsider. True, hedge funds typically charge 2 per cent per year, while taking an additional 20 per cent of their investors’ profits. But let’s estimate the returns of global hedge funds before fees.

If the typical hedge fund earned 5 per cent before fees over the past decade, 2 per cent would be deducted as an expense ratio, leaving a 3 per cent return. Now subtract 20 per cent of the profits. Coupling the expense ratio with a 20 per cent profit slice would leave a 2 per cent post fee result, from an original 5 per cent return.

Unfortunately, the typical hedge fund did even worse, earning 1.6 per cent per year, not 2 per cent. Roughly speaking, if the typical fund manager worked for free, and if the investment firms didn’t charge, these masters of the universe would still have underperformed a balanced index since 2003, by roughly 2.5 per cent per year.

Canadian hedge funds have also come under fire recently, getting hammered by a combination of Canadian stock and bond indexes since the end of 2010. Our fund managers, too, could have charged nothing for their services over the past couple of years, and their investors would still have lost to a Canadian balanced index.

This isn’t a slam on hedge fund managers, however. They’re among the smartest money managers in the world. It does prove, however, how tough it is to beat the market.

Just ask John Paulson about that. The celebrated hedge fund manager bet against the U.S. housing market, prior to its collapse, earning a reported $15-billion for his firm.

The remarkable story was documented in Gregory Zuckerman’s, The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History. Unfortunately, since then, his results have been dismal.

In 2012, Paulson’s Advantage Fund underperformed the S&P 500 by more than 27 per cent (losing 14 per cent for the year). In 2011, he did even worse, dropping more than 37 per cent to the index. A $10,000 investment in this storied fund, just two years ago, would have dropped to $5,418 by the end of 2012.

So if you’re trying to decide whether to index your nest egg or build a portfolio of individual stocks, consider your odds. To beat the market, you’ll have to be a better stock picker than most hedge fund managers.

If you don’t think you are, align with the tortoise’s camp.

 

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