Not many investors want their money to track an index when stocks fall. That’s especially true with COVID-19 causing investment panic. Businesses are shut. Unemployment is soaring. Stock markets are making huge swings. A lot of investors are looking for active trading solutions in this environment. Some high-net-worth investors are thinking now is the time for hedge funds.
According to investment lore, hedge funds make money during good times and bad. At the very least, they limit losses when stocks crash. Hedge-fund managers can short the market if they think stocks will plunge. They can switch into cash, gold, bonds or a specific market sector that might weather the latest storm. And when hedge-fund managers sense a recovery, they can jump back into the stocks that will ride the rocket higher. If you’re an ETF investor, you can learn from what they do.
Scotiabank compiles Canadian hedge-fund returns and, between January, 2005, and Jan. 31, 2020, its report says the equal-weighted returns of Canada’s hedge funds matched the S&P/TSX Composite Index. That’s impressive, especially if they were able to do so while exposing investors to lower risk.
There’s plenty of mystique around hedge funds. But ETF investors shouldn’t feel left out. After all, a hedge-fund manager’s tactical trading usually does more harm than good. If you sidestep their mistakes with a portfolio of ETFs, you should beat their returns during good times and bad.
First, let’s pull back the wizard’s curtain to get a clearer view. When Scotiabank’s hedge-fund report references the U.S. and Canadian stock market returns, it doesn’t include reinvested dividends for the indexes. That’s like reporting the speed of a car after taking off a wheel. In other words, Canada’s hedge funds haven’t come close to matching the returns of the Canadian or U.S. stock market indexes over the past 15 years.
Between Dec. 31, 2004, and Jan. 31, 2020 (the latest date from which data is available), Canadian hedge funds averaged 4.25 per cent a year. These returns included surviving funds only. When a hedge fund closes after a dismal run, it rarely reports its final plunge. That’s why U.S. economist Burton Malkiel says compilations of average hedge-fund returns are always overstated. As Scotiabank reports, “The data used to construct the [hedge-fund] Index is provided on a voluntary basis by the constituent funds and is not reviewed, audited or independently verified.”
Still, even the hedge funds that survive don’t perform as well as people think. For example, iShares Core S&P/TSX Capped Composite Index ETF (XIC) gave Canada’s surviving hedge funds a whooping. It averaged a compound annual return of 7.24 per cent over the same period. That beat the typical surviving Canadian hedge fund by 52 per cent.
Over the same duration, the SPRD S&P 500 ETF Trust (SPY) of U.S. stocks averaged about 9.4 per cent a year, measured in Canadian dollars. That trounced the average surviving Canadian hedge funds by a whopping 108 per cent. (No such non-Canadian hedged version existed on the TSX prior to about 2012).
A balanced portfolio of ETFs comprised of 30 per cent Canadian stocks, 30 per cent global stocks and 40 per cent Canadian bonds beat the hedge funds, too. It would have averaged a compound annual return of about 6.73 per cent after fees over the same period. That beat the average surviving Canadian hedge fund by 42.5 per cent.
You might wonder, however, how a diversified portfolio of ETFs stacked up to Canadian hedge funds when the world last turned upside down. According to Scotiabank, in 2008, the average Canadian hedge fund dropped 22.64 per cent. That compares with a drop of about 15.81 per cent for a globally balanced portfolio of ETFs (30-per-cent Canadian stocks, 15-per-cent U.S. stocks, 15-per-cent international stocks and 40-per-cent Canadian bonds).
It’s tempting to think we should juggle our ETFs while markets jump around. We might think we can choose sector-specific ETFs to weather or capitalize on future market opportunities. But there’s much to learn from professional traders at the helm of Canada’s hedge funds. They’re trained to do this. But over time, most still disappoint.
Canadian hedge fund managers aren’t the only tactical asset traders who fall short of expectations. Between Dec. 31, 2002, and Dec. 31, 2019, U.S. hedge funds, as measured by the HFRX hedge-fund index, averaged a compound annual return of just 1.74 per cent, measured in U.S. dollars. In contrast, a globally diversified portfolio of ETFs (60-per-cent global stocks, 40-per-cent bonds) averaged a compound annual return of 7.65 per cent over the same period.
Hedge funds charge high fees, often 2 per cent each year plus a performance incentive if they do well. Ironically, however, American hedge-fund managers could have worked for free and a balanced portfolio of ETFs would have still outperformed.
That doesn’t mean these hedge-fund traders aren’t smart. Most are brilliant, in fact. But if you want to increase your odds of investment success, don’t try to see the future. Instead, build a diversified portfolio of low-cost ETFs. If the markets plunge and your allocation deviates more than 10 per cent from your asset allocation goal, then rebalance it. Over time, you’ll beat the returns of most tactical traders.
If this requires too much effort, consider an all-in-one ETF portfolio from BMO, Vanguard or iShares. Each all-in-one ETF represents a complete portfolio of Canadian stocks, U.S. stocks, international stocks and bonds wrapped into a single fund. Each also charges low fees of between 0.20 per cent and 0.25 per cent per year. The fund companies also rebalance these ETFs to maintain their original target allocation. In other words, unlike active traders, they don’t speculate.
Conservative investors might like BMO’s Conservative ETF (ZCON) or Vanguard’s Conservative ETF Portfolio (VCNS). They each include about 60 per cent bonds and 40 per cent Canadian and global stocks. Despite their low stock exposure, such allocations beat the aggregate return of surviving Canadian hedge fund from 2005-to-2020. It would have also trounced most hedge funds in 2008, dropping about 8 per cent, compared to a loss of 22.64 per cent for the typical Canadian hedge fund.
Investors who don’t mind taking slightly more risk could choose BMO’s Balanced ETF (ZBAL), iShares Core Balanced ETF Portfolio (XBAL) or Vanguard’s Balanced ETF Portfolio (VBAL). Each fund includes 40 per cent bonds and 60 per cent Canadian and global stocks.
Investors with a higher appetite for growth (which accompanies volatility) could choose BMO’s Growth ETF (ZGRO), iShares Core Growth ETF Portfolio (XGRO) or Vanguard’s Growth ETF Portfolio (VGRO). They each contain about 20 per cent in bonds and 80 per cent in Canadian, U.S. and international stocks.
If you choose one of these funds, keep it. Don’t switch to a more conservative fund after markets fall, or switch to a more aggressive fund after stocks rise. Instead, determine your tolerance for risk and stick to a single fund. If your investment costs are low, and you don’t mess around, you should trounce the returns of most high-status hedge funds.
Andrew Hallam