Why do people invest in hedge funds?
Just saw this graph -- the average hedge fund far underperforms the S&P 500 index. My question is, why do people invest in hedge funds (and pay for the enormous fees) if they can just get a higher return in VOO or QQQ? Am I missing something? This may be a really dumb question, but genuinely curious
Diversification, paying for alpha, uncorrelated returns etc. An average hedge fund is a bit of a misnomer, its a field that rewards the top x%. Look at the podshops like Citadel and Point72 being up significantly on the year whilst indices are down.
Try telling a pension fund to stick their money in QQQ and they'll die of shock.
Some institutions want alpha. What is alpha? Alpha is returns excluding beta. What is beta? In simple terms, exposure to the market. What is QQQ? A levered market etf i.e. levered beta. Literally the opposite of what the institutions want.
Ask yourself. Why do people invest in bonds? Real estate? All of these above underperformed the S&P. Ask yourself why do people not invest all their money in PE when it outperforms the S&P? The answer to these questions is the same.
I don’t get you people. I really do not. Do you lack IQ or the ability to think independently? The market is a competition. No shit. An equivalent question would be, what is the average finish of a runner in a marathon? The average has no significance in a competitive environment.
Lol? There are like 27k hedge funds in the world and less than 1% of them beat the market.
Warren Buffett literally said hedge funds are shams since the top "investment pros" (even the top hedge funds) can't beat the market on average. He advocates for investing in index funds. So unless you know more than Warren Buffett, sit tf down prospect in AM.
I love the irony of being told to index by Warren Buffet - a guy who has literally made a fortune by not indexing...
How am I the 10th person to reply to this thread, yet the first to mention Risk (the other side of the reward calculation)? Trying looking at proper metrics which incorporate both.
Secondly, you’re looking at 10 of the greatest years in history to be levered long beta because of the immense liquidity in markets post gfc.
third, it’s absolutely true that many of what people call hedge funds are not that. They’re levered long-leaning beta plus essentially portable alpha.
Other people are saying this but to clarify. If you manage $10bn for a pension fund or for a university endowment, your goal is to meet funding needs in +20 years and grow that money at a solid rate. You cannot lose that money because it is needed / already promised for various uses. Think about how to diversify that money and generate strong compound returns over decades without taking too much risk that you will fall short of funding needs (remember how much volatility and down years hurt your long term performance).
True hedge funds deliver returns/alpha within very specific risk/return parameters, which is very valuable for these clients. If you know citadel can make you 10%-20% per year in equities no matter what happens in the broader markets, that is very very attractive, especially if most of it is alpha. Then you have some managers who you pick because they tend to generate amazing returns in strong bull markets by picking the winners throughout that period (and are supposed to be hedging out risk to the downside...) like the tiger cubs. Or you have a niche biotech doctor guy who you give a smaller allocation to capitalize on healthcare trends. Or you have a macro guy just trying to beat the bond yields (which for the last decade gave you nothing). A macro fund is not looking to beat SP500 so that is a very poor benchmark.
There are a variety of funds/strategies that all fulfill various investment needs for these institutional investors, and that is how you get so many.
At the end of the day, there are tons of funds that offer subpar returns with little differentiation because the incentive structure of the vehicle is attractive for the founder, but those tend to not last very long. Looking at averages for hedge funds vs. SP500 is useless, but the largest and most successful funds tend to offer that attractive alpha + risk/return setup against their designated benchmark. Then at the end you are left with a handful that are special and just trying to deliver absolute returns but may not have great sharpes/alpha generation, but those guys have been around for 30 years and the reputation + absolute returns + client relationships have been good enough over a long enough period of time that they stay in business.
Because how else are you supposed to justify your pension fund manager position by investing in the S&P?
Two already really good posts on here regarding both 1) risk management and 2) allocator preference by @HFPM and @mtnmaster1. Think the only thing I have to add is historical context that was alluded to in an early reply.
When markets aren't going up and to the right constantly and we've experienced a low-rate environment, you see a multitude of things happen. Levered beta outperforms as markets go up at low risk (risk-free at/near 0%). It's why private equity has done extraordinarily well. Rates dictate valuation broadly across markets as people care about cost of capital. People care about cost of capital because of shareholder returns and free cash flow generation. And people care about free cash flow generation because in a margin of safety exercise cash flow is all that matters. When debt is free, any investment that relies on leverage becomes a good one, especially when valuations have room to run if rates are staying stagnant at low levels as both WACC is solidified or fixed at a lower level and margins can grow as a result (typically, not always).
I think the real issue in the long/short world is that for years the SM industry has become ultra-sector focused in a result of believing they could identify alpha in idiosyncratic ways, when actually the rise of ETF-based investing, indexing, and factor-trading algos have moved all stocks of a similar vein in highly correlated directions. Was there a material difference in owning software co A and software co B over a 5-year time horizon from 2014-2019? Probably not much. Citadel exists to exploit the very alpha capture that exists on earnings and within the early weeks of a trade, with all market risk hedged out. Large allocators love consistent returns with little risk, and from a procedural perspective they likely repeatability. If Citadel can generate 15% in an up 20-25% year but also generate 10-15% in a down 15% year, a risk-averse allocator will take that bet every time.
To the note on the Q's. The market is down ~16% as of writing this and the Q's are down 28% YTD. If you're a pension with fairly strict risk parameters, the exercise in investing in a 2x levered market ETF at no cost is exactly that. The bottom line and people forget this is: if you compound at 20% a year for 5 years, but then lose 60% of that in any given period of time, you're still losing 60% of whatever you generated in those 5 years. People tend to forget that % gains are not perfectly convex on both sides of a PnL.