Hedge funds are bad and they should feel bad

Hedge funds are bad and they should feel bad

For the average Joe investor, it’s pretty easy to advise that they don’t invest in a hedge fund. Hedge funds promise active investment and a baseline return. Because they’re running active investments, hedge fund managers usually say that they can beat the market. In turn, they’re more expensive than passive investments, an example of which is throwing all of your extra income into a simple Vanguard fund.

But even if you have the extra cash to throw into a hedge fund, it may not be such a great deal. According to a new paper by Mikhail Tupitsyn and Paul Lajbcygier of Australia’s Monash University, the majority of hedge funds can be classified as passive. And when we say majority, we mean as many as two-thirds of the hedge funds they studied were passive.

What’s the difference between passive and active? Active management is supposed to be based on a manager’s analytical expertise; based on their knowledge of the market, they’ll try to get above-average returns on your dollar. Passive management is as simple as tracking an index, or in the case of some robo-investors, creating a portfolio of a few index funds.

So what are you paying the hedge fund manager for? In short – not much! Here’s another funny tidbit (well, funny to anyone who doesn’t have money in a hedge fund): the majority of active funds underperformed the market by as much as 0.1%. In this case, you’re paying the hedge fund manager to lose money for you.

Even the hedge fund managers with amazing skill – a true minority – didn’t stay that way for the long run.

I don’t claim to know how the super wealthy should use their money, but if I woke up with a few billion dollars tomorrow, I wouldn’t waste it on a hedge fund. And for the average investor, simple Vanguard funds or a robo-investor like Betterment, Wealthfront, or FutureAdvisor is a much better bet than trying to play the market.

Some of these robo-investors claim to be better than your average hedge fund, even for the super rich – Wealthfront claims to perform 28% better than hedge funds when you add in tax-loss harvesting and direct indexing. Wealthfront says that tax-loss harvesting is usually only available to those with more than $5 million invested, but their tax-loss harvesting is available to all customers; direct indexing is available to those with at least $100,000 in their account.

Not all passive investment services are created equal – Wealthfront recently got into a public spat with Betterment over who had the lowest fees for small accounts. Before putting your money into any investment product, do your research and make sure your expectations match the reality of what that product can offer.

Image: Tim Green