Once upon a time, a “hedge fund” referred to a strategy of balancing long and short positions in stocks to “hedge” market risk.

Fast forward to today, and hedge funds have morphed into a wide array of investment vehicles, utilizing a wide variety of financial instruments, leverage, high fees, and strict withdrawal restrictions. They aim to deliver returns that are less volatile and minimally correlated with the broader equity market.

However, the reality isn’t quite so rosy. Researchers have uncovered significant flaws in hedge fund performance data. For instance, a paper by Ibbotson and Chen in the Financial Analysts Journal revealed that the average hedge fund’s return plummeted from 14.9% to 7.7% after adjusting for survivorship and backfill biases.

And Asness, Krail and Liew have also pointed out that the touted low volatility and low correlation of hedge funds might be more illusion than reality.

Additionally, Morgan Stanley’s research indicated that hedge funds have become increasingly correlated with the S&P 500 Index, diluting the diversification benefit that was once their hallmark.

Sure, there are a few hedge funds whose long-term success stories make headlines. But these are exceptions, not the rule.

The evidence that hedge funds add value just isn’t compelling. What is certain is their cost – research shows that the all-in cost of hedge funds exceeds 3% per year.

When it comes to hedge funds for the average individual investor, I have to give a thumbs down. The high costs and questionable benefits just don’t add up.

Sources cited:

1. ”The A,B,Cs of Hedge Funds: Alphas, Betas, and Cost”, Yale ICF Working Paper No. 06-10, September 2006, by Roger Ibbotson and Peng Chen (Subsequently updated and published in Financial Analysts Journal, January/February 2011)

2. “Do Hedge Funds Hedge” by Asness, Krail, and Liew
https://www.aqr.com/Insights/Research/Journal-Article/Do-Hedge-Funds-Hedge

3. “U.S. Equity Strategy”, a Morgan Stanley Publication, July 10, 2013