By Dr. Vinay Nair
Managing Partner and CEO, Ada Investments
Two thousand and thirteen was yet another year of underperformance for hedge funds. Several headlines have highlighted this and drawn important conclusions about the demise or transformation of hedge funds. In fact, hedge funds have underperformed the overall equity index in the last five years.
Click Image to Enlarge
Looking further back, hedge funds have outperformed the overall equity market in only seven out of past 19 years. That’s around one-third of the time.
Click Image To Enlarge
Annual outperformance or underperformance is, however, misleading and potentially dangerous to the objective of maximizing wealth. Here’s how a dollar invested at the beginning of 1995 would fare in the S&P 500, in the overall hedge fund index and in the equity hedge fund index. Despite only one-third of excess positive years, the equity hedge fund index handily outperforms S&P 500 (by $1.27 for $1 invested).
Click Image To Enlarge
This is a result of a simple but powerful fact – compounding.
An important role that hedge funds are designed to play in a portfolio is that of providing return stability. This return stability translates into lower losses during the rainy days and therefore, more money to invest during the sunny days ahead. Rainy days are indeed fewer than the sunny days and so it is not a surprise that hedge funds underperform broader equity market index most of the years. As many savvy investors are aware, paying for return stability has short term costs such as underperformance to the market but is a good long term investment strategy.
An investor who does not appreciate this fact is likely to pull capital out of hedge funds after a poor run of years such as now or such as in 2007 or in 1998. In fact, consider what happens to a disgruntled investor who first invests a dollar in the hedge fund index in 1995 but then moves it to equities in 1999 after annual underperformance of 4 years. The investor wealth at the end of 2013 is only $4.5. Sticking to the equity hedge fund index would have generated an extra $2.43.
Dr. Vinay Nair is the Managing Partner and CEO of Ada Investments, an investment management company focused on providing liquid solutions to institutional and private clients globally. Ada's investment philosophy centers on the belief that fundamental research ideas used to select securities can be evaluated using empirical techniques and executed through a disciplined rules-based approach. The firm has offices in New York, NY and Mumbai, India. Before founding Ada, he was the Research Director and a Portfolio Manager at Old Lane (Citi Alternative Investments).