Skip to Content
Alternative Investments

Are Hedge Funds Now Worth Considering?

In 2022, they delivered on their promises.

Illustrative photograph of John Rekenthaler, Vice President of Research for Morningstar.

Out of Favor

In “Hedge Fund Performance: End of an Era?” (Nicolas Bollen, Juha Joenväärä, Mikko Kauppila), the authors found that from 1997 through 2007 an equally weighted index of hedge funds gained an annualized 11%, as opposed to 8% for U.S. stocks, slightly more for their foreign counterparts (it’s hard to believe these days, but sometimes it helps to diversify internationally), and 6.5% for domestic bonds. As a group, hedge funds were also less volatile than equities.

That, obviously, was a winning combination. So winning, in fact, that investors expected ongoing miracles from hedge funds. In 2008, the investable composite index of hedge funds, computed by Hedge Fund Research, dropped by an average of 18%, with equity hedge funds losing 25%. While disappointing, that result easily bettered the global stock market, which fell by more than 35%. But investor expectations for hedge funds had become so inflated that their losses came as a shock. Suddenly, the industry possessed all the glamour of a bunny chain.

(Usually at this point, I accompany the text with a colorful graph. But not today. Hedge Fund Research helpfully permits registered users to download its indexes’ return data, but unhelpfully accompanies that information with a Terms of Use that, by my reading, prohibits me from publishing charts generated from those numbers. So, today’s column is for adults only; no pictures to assist the children.)

The Culprits

The industry’s decline owed to two factors. First, hedge fund assets grew almost 20-fold in a decade, from just over $100 billion in 1997 to almost $2 trillion entering the global financial crisis. This expansion both diluted the industry’s managerial talent and—happily for financial markets’ efficiency but distressingly for hedge fund shareholders—shrunk its investment opportunities. Far more money chased the same deals, thus shrinking arbitrage spreads and each transaction’s profits.

Second, the easy trade disappeared. Entering the New Millennium, technology-company prices had reached levels not seen before or since (even at their recent peaks, such stocks were 30% cheaper than in December 1999). Sensing danger, hedge funds almost completely dodged the ensuing technology-stock collapse. That single, huge decision greatly boosted their relative performance.

Unfortunately for shareholders, hedge funds have subsequently enjoyed few similar circumstances. To be sure, the stock market has periodically crashed, but as a group hedge funds cannot time the overall market. Rather, the industry thrives when its managers can exploit differences in relative value—that is, when they can find times when some stocks rise, while others fall. Such did not occur in 2008, nor often since then. The stock market’s tides have mostly moved in unison.

The 2022 Rebound

According to HFR, its investable equity-fund index dropped 12% in 2022, as opposed to a 19% decline for U.S. equities. That result may not entirely satisfy hedge fund skeptics, as the group still suffered a double-digit loss. However, in a year when stocks and bonds across the globe were rocked, the 3% loss sustained by HFR’s composite index, which includes all flavors of hedge funds, surely deserves praise. The industry once again earned its keep.

Unfortunately, that result still leaves hedge funds behind the better public funds. HFR’s investable composite index began operations in January 2005. Since that time, it has gained an annualized 4.9%, which is considerably lower than the gains for two Vanguard funds that are hedge fund rivals, Vanguard Balanced Index VBINX and Vanguard STAR VGSTX. As with HFR’s index, those Vanguard funds hold a broad mix of securities, including both stocks and bonds. But their annual returns have been 200 basis points higher.

In defense of hedge funds, HFR’s index has performed very steadily. Combining nearly 500 funds, as HFR’s benchmark does, greatly reduces volatility. Over that period, the standard deviation of HFR’s index has been barely above that of Vanguard’s Intermediate-Term Investment-Grade VFICX bond fund. Individual hedge funds are notoriously dangerous, but when collected by the hundreds, and diversified among investment strategies, they are remarkably stable.

Looking Forward

Regrettably, I do not believe that hedge funds’ recovery is sustainable. While the industry last year profited by shunning growth stocks and long-term bonds that had become overpriced (at least in hindsight), those relative gains have already been booked. And it seems unlikely that strategy will remain fruitful. At 26, the price/earnings ratio on the Vanguard Growth Index VIGRX is not much above its historic norm, and the yield on Treasury notes is near its 10-year high.

Also, despite my gibes, the money is back. After languishing for several years following the global financial crisis, as disappointed investors redeemed their shares, hedge fund assets have recently boomed. Hedge funds currently possess almost $5 trillion, more than triple what they held a decade ago. Consequently, they once again are keeping the markets efficient, while squeezing their own profits. It’s hard to see how hedge funds can prosper without finding another big trade.

Of course, one need not buy the averages. My analysis therefore is moot for those who, despite the paucity of research data, can find 1) abnormally good funds that 2) have not yet been discovered and 3) are open to new investors, while 4) avoiding the industry’s occasional bombs. Good luck with that.

Outdated Regulations

Currently, hedge funds are only available to “accredited” investors who meet either income or wealth requirements (or who qualify in other ways, such as owning a securities license). That the investment minimums have not changed since 1982 bears witness to how little lawmakers care about these rules. They realize that the accredited-investor mandate is a dusty vestige. When anybody with a debit card can buy cybercurrencies backed by absolutely nothing that are hawked on television, why prevent them from buying hedge funds?

House Republicans are currently proposing to amend the accredited-investor rules. Although I distrust their motives, as their statements appear to have been ghostwritten by Wall Street marketers, I share their conclusion: “A person’s economic status may demonstrate an ability to withstand losses, but it certainly does not demonstrate financial sophistication.” True that. Let the people choose.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

More on this Topic

Sponsor Center