As inflation and the markets continue to gyrate, many investors are wondering where to put their money.
Hedge-fund managers whisper solutions: They can short the market when they believe the time is right. They can also shift money into alternative investments which could thump inflation.
Hedge funds, however, are exclusive clubs. In most cases, investors must earn at least $250,000 a year or have a minimum net worth of $1-million just to get inside. That slams the door on plenty of people. If you’re feeling left out, here are a few things to know:
First, the hedge fund industry wants you to believe they can beat the market with less volatility. Not true. Diversified portfolios of exchange-traded funds (ETFs) are less volatile and trounce the performance of most Canadian hedge funds.
For proof, let’s pull away a curtain of deception.
In 2015, the Bank of Nova Scotia’s Canadian Hedge Fund Index performance tables demonstrated that Canadian hedge funds thrashed the performance of the S&P/TSX 60 Index from 2005 to 2015.
According to Scotiabank, Canadian hedge funds nearly matched the high-flying performance of the S&P 500 Index of U.S. stocks over the same period. At first, I was impressed.
But in those comparisons, Scotiabank failed to include dividends for the Canadian and U.S. stock market indexes. After I complained in 2020, a Scotiabank representative told me via e-mail: “We will report a YTD [year-to-date] and rolling 12-month total return figure on a go-forward basis for the S&P 500 Index. Our index provider does not collect total return index data for the TSX 60.”
However, Scotiabank’s latest chart, updated to April 30, 2022, still fails to include dividends for the S&P/TSX 60 and the S&P 500. It counted dividends for the hedge funds but failed to count dividends for Canadian and U.S. stocks.
That’s like Dodge comparing the speed of an old Caravan to a Porsche Cayenne – after flattening one of the Porsche’s tires. Is that ethical? No way.
A $10,000 investment split equally between Canada’s hedge funds would have grown to just $23,134 from Jan. 1, 2005 to April 30, 2022, or 131 per cent.
That pales compared to Canadian and U.S. stocks when dividends are included: The iShares S&P/TSX 60 Index ETF (XIU-T) would have grown to $38,565 over the same period, or 285 per cent. The S&P 500, measured in Canadian dollars, would have grown to about $49,609, or a gain of 396 per cent over the same time frame.
Some investors might still wonder if hedge funds fill the urban promise of making money when stocks crash. Unfortunately, there’s little evidence of that, too.
Equally weighted, Canada’s hedge funds dropped 22.6 per cent in 2008, the last sustained major market meltdown. In contrast, a portfolio comprising 60 per cent in the XIU ETF and 40 per cent in the iShares Core Canadian Universe Bond Index ETF (XBB-T) dropped just 17.5 per cent in that same year.
If you want to diversify further and try to beat the long-term performance of most Canadian hedge funds, here’s how with ETFs:
Put 40 per cent of your money in a Canadian bond market ETF, such as XBB or Vanguard’s Canadian Aggregate Bond Index ETF (VAB-T). Then, split the remaining 60 per cent equally across a Canadian stock index, such as BMO’s S&P/TSX Composite ETF (ZCN-T), and global stocks, such as Vanguard’s FTSE Global All Cap ex Canada ETF (VXC-T). Rebalance once a year to maintain a consistent allocation.
If that’s too much work, you could invest everything in an all-in-one portfolio ETF. For example, there’s the iShares Core Balanced ETF Portfolio (XBAL-T) and BMO’s Balanced ETF (ZBAL-T), each of which includes about 40 per cent in Canadian bonds, with the rest split between Canadian and global stocks. Moreover, each fund company ensures their all-in-one funds maintain a consistent allocation. In other words, you won’t have to rebalance.
There are two reasons investors in diversified portfolios of ETFs beat most hedge funds. First, ETFs charge lower fees. Second, despite whispers to the contrary, the tactical trading done by most hedge-fund managers dishes out more pain than profits.
ETF investors can learn a lot from hedge-fund managers’ mistakes. For example, when stocks drop, hedge-fund managers try to limit losses. By doing so, they miss out on big gains when stocks recover.
Based on Scotiabank’s 2005 to 2022 data on hedge-fund returns, that happened almost every time stocks declined. For example, in 2011, the S&P/TSX 60 Index dropped about 8.5 per cent. That year, the S&P 500 gained just 4.4 per cent, measured in Canadian dollars.
Canadian hedge funds dropped just 3.8 per cent in 2011. But because hedge-fund managers were busy shorting the market, rushing into cash or seeking alternative investments, they were poorly positioned when stocks rose the following year.
In 2012, the S&P/TSX 60 Index and the S&P 500 gained 7 per cent and 13.5 per cent, respectively, measured in Canadian currency. Meanwhile, Canada’s hedge funds lost another 4.7 per cent. That gave the hedge funds a two-year return (2011 to 2012) far below that of both North American indexes. Based on data provided by Scotiabank for 2005 to 2022, the same thing happened during almost every two-year period that began with a market drop.
The take-away for ETF investors? Stay the course – even when inflation and the markets swing. Don’t try to limit short-term losses. Also, ignore hedge-fund hype and the sneaky ways they try to make their performances look good.