SKARBECK: High-quality stocks perform as well as alternative options

Investors’ fascination with alternative investments has meant more money flowing into hedge funds in recent years. That puzzles some observers because most hedge funds have failed to outperform index funds since the credit crisis.

According to Hedge Fund Research Inc., hedge funds returned 13 percent annually from 1993 to 2007, compared with 8.9 percent for the Vanguard Balanced Index Fund. Since 2008, hedge funds have underperformed, returning an average of 0.9 percent per year compared with 3.8 percent for the Vanguard Balanced Index Fund. Funds-of-funds—hedge funds that invest in other hedge funds—returned an average of 9 percent between 1993 to 2007 and have lost 2.5 percent annually since 2008.

Simon Lack, author of “The Hedge Fund Mirage,” believes some blame lies in the size of the hedge fund industry. “You have more money chasing fewer opportunities,” Lack told Bloomberg.

One of the key draws to hedge funds was a claim that they were uncorrelated to the stock market. That seemed appealing to many institutional equity investors whose returns in the stock market over the last decade have been subpar. For example, “market neutral” hedge funds that both buy stocks and sell stocks short, were advertised as a way to make money whether the stock market went up or down.

However, the long/short theory hasn’t worked in real world. In May, a Vanguard paper on hedge fund performance concluded that many hedge fund categories were “strongly correlated with a 60/40 portfolio of stocks and bonds.”

Of course, most hedge funds charge hefty fees that are supposedly justified by their ability to deliver higher returns. The standard price of a 2-percent management fee and 20 percent of profits has directed billions in fees to managers with mediocre returns that have merely tracked the index.

So why do institutions and other well-heeled investors continue to pay big for pedestrian performance? Institutions have been advised by the investment consulting industry to funnel money into hedge funds in an effort to emulate the great success that Yale University achieved in the 1990s.

Yet David Swenson, the architect of Yale’s endowment success, is less sanguine about hedge funds these days. Speaking at a Bloomberg conference in January, Swenson noted that hedge funds fees are a “huge issue” and are unmerited without extraordinary performance.

Investors can watch this debate play out in a wager Warren Buffett has with Protege Partners, a fund-of-hedge-funds group. Buffett bet that the S&P 500 index would outperform an average of five hedge funds selected by Protege over a 10-year period.

The first year, 2008, was disastrous for both: The S&P index lost 37 percent, while Protege’s hedge funds lost 24 percent. Since then, the S&P index has fought back; in the four years ending 2011 it lost -6.27 percent, vs. a -5.89 percent loss for the hedge funds. The contest is tracked on longbets.org and the winner will donate $1 million to charity.

For the past year, we have said that investors didn’t have to do anything fancy and that simply owning high-quality U.S. stocks was as attractive as any other alternative. Since the end of last August, an S&P 500 index fund is up about 18 percent.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.