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Hedge funds are a racket, in 2 charts

Hedge funds are great for Greenwich, CT, real estate prices, but not so good for their customers.
Hedge funds are great for Greenwich, CT, real estate prices, but not so good for their customers.
Spencer Platt/Getty Images

Hedge funds are actively-managed investment plans that are supposed to help wealthy investors (as well as institutions such as pension plans) beat the market. Symmetric, a website that rates hedge fund investors, crunched the numbers and found that a lot of hedge funds didn't do so well in 2014:

Symmetric looked at the stocks each hedge fund invested in, and then compared them to the average performance of other stocks in the same category. For example, "if a manager picked Apple, did it perform better than the tech sector?" The bars in this chart show how each hedge fund performed compared to someone who just bought all the stocks in the categories hedge funds chose.

As you can see, the results are not pretty. Fewer than 20 percent of hedge funds achieved better returns than they would have gotten if they'd just invested in broad industry categories. Over a longer, three-year time horizon, hedge funds appear to have done about as well as the broader market, with about half of hedge funds earning above-average returns and half earning below-average ones.

So does this mean people (at least those rich enough to invest in hedge funds in the first place) should buy into one of the funds with the above-average returns in 2014? Probably not. While it's possible that these funds are run by managers with a knack for beating the market, there's also a good chance they just got lucky. Studies have shown that it's very difficult to beat the market, and most mutual funds that try to do so fail. A fund that over-performs one year is just as likely to under-perform the next year. There's little reason to think hedge funds are different.

But hedge funds have a huge disadvantage over most other investment vehicles: every year, they generally charge customers two percent of the funds invested, and 20 percent of any profits earned on top of that. That acts as a consistent drag on returns. This might explain why the average hedge fund has dramatically under-performed the broader market over the last decade, as shown in this chart from Mark Perry:

Graph showing hedge funds underperforming the S&P 500 on average.

AEI / Mark Perry

A better investment strategy is to simply accept that you're not going to be able to get above-average investment returns and focus instead on keeping management expenses as low as possible.

Update: Hedge funds think it's unfair to compare them to a portfolio of stocks and bonds. "Whether it is portfolio diversification or risk management, each hedge fund allocation is done to meet specific needs and performance is only accurately measured against that objective, not unrelated investments like stocks or bonds," says Nick Simpson, a spokesman for the Managed Funds Association.

Still, if your goal is to enjoy a comfortable retirement, then you should care about whether these funds can outperform stocks and bonds. Investing in low-cost index funds is likely to be a better choice.