The appeal of hedge funds has generally stemmed from how they can add genuine diversification to a portfolio – in other words, the way they can be relied upon to react differently from more ‘traditional’ investments, such as equities and bonds. According to analysts at Morgan Stanley, however, they are in danger of losing that attraction as they more and more resemble ‘closet’ index-tracking funds.
The chart below shows the correlation of five-year rolling returns from the broad S&P 500 index of US companies and the HFRI equity hedge index – effectively an average hedge fund – over the period from January 1990 to June 2013.During that time, the correlation has risen from 0.6 to 0.9 – with a correlation of 1 implying the two would move in lockstep and one of 0 suggesting no relationship at all.
Over the same period, as the chart below shows, the average equity hedge fund’s outperformance over the S&P 500 has fallen from close to 15% to what over the last year or so has been a negative number. If you were paying, say, an annual charge of 2% and a performance fee of 20% of any outperformance for your hedge fund, you may not feel you were getting your money’s worth.
The point of this article is not to bash hedge funds – that is just a happy by-product – but to use the above scenario to illustrate what is known as ‘the rule of 72’. This is a useful rule of thumb that allows you to estimate the compound rate of return on an investment – or at least gain a rough and ready indication of how long it will take that investment to double in value.
All you do is divide 72 by your expected rate of return or interest rate and the result is, near enough, the time in years it will take your investment to double. Thus, for example, an equity investment returning you 12% a year will take six years to double in value while a savings account paying you 2% a year will take 36 years to do so.
What the rule of 72 also tells you is, if you are paying 2% a year in fund fees then, in an environment of no absolute return, you will halve your investment every 36 years. To put it another way, always guard against paying much more than an index tracker to receive similar returns.
For the sake of fairness, we should note the returns and correlations referred to above are averages and naturally there are some very good and uncorrelated hedge funds still to be found – even if picking those out in advance remains a considerable challenge. We could of course point you towards an investment strategy with a proven long-term track record of generating outperformance net of fees – it is called value investing.