Studies have shown, over and over again, that hedge funds as a class provide investors with worse returns than simple passive investment strategies.
But a new study by Mikhail Tupitsyn and Paul Lajbcygier of Monash University suggests that the ripoff is in some ways more fundamental than that — most hedge funds don't appear to be doing any hedging or active management at all.
To reach that conclusion, the authors took a large set of hedge funds that deploy a variety of investment strategies and researched whether the funds exhibit linear or nonlinear returns relative to broader markets. The math behind this gets pretty funky, but the basic idea is that linear returns are simply proportional to what you could get with an index fund, whereas nonlinear returns aren't correlated with a simple index.
The theory of a hedge fund, after all, is that it is going to employ some kind of active strategy that gets you a return that's different from just big overall market changes. What the authors find is that in most cases this doesn't happen: "Over the long run many hedge funds behave like alternative beta portfolios and maintain linear exposures to systematic risk factors."
Think of how a recent, less technical study showed that Apple, Facebook, and Google are three of the most widely held hedge fund investments.
These are great companies. And obviously the US high tech sector has done well recently. But owning funds that own stock in gigantic, famous technology companies is just earning you generic exposure to the tech sector minus huge management fees.
The real punchline, though, is that not only is it rare for a hedge fund to have returns that are materially different from what a passive strategy could obtain, but the genuinely active minority exhibits inferior performance. "The overall raw returns of nonlinear funds are 0.1 percent lower than returns of linear funds," the authors find.
In other words, if you buy into a hedge fund hoping to take advantage of an active management strategy, you probably aren't going to get one. And if you do manage to obtain nonlinear exposure to broader market risk, you're going to be even worse off than you would have been if you failed. In other words, even if you're rich enough to gain access to exotic investment materials, you want to follow the same basic investing advice as anyone else — make sure to save enough, own stocks for the long term, and stick to passive strategies rather than trying to beat the market.