Hedge funds still aren’t worth the money: Part 2

Last week, I showed how the average hedge fund struggles to add value above and beyond what a simple low cost 60/40 stock/bond portfolio can do. The one thing, a 60/40 portfolio couldn’t do, however, was provide low correlation to stocks and bonds, though admittedly, once an investor holds hedge funds for 12 months or longer, the return fluctuations of hedge funds look like a 60/40 portfolio. And once again, I emphasise that I am talking about the average hedge fund as reflected in hedge fund indices and diversified hedge fund portfolios, not any specific fund.

Almost a decade ago, I wrote a post for the CFA Institute Enterprising Investor blog that used an idea developed by Jakub Jurek and Erik Stafford to replicate the performance of hedge funds. In essence, the post showed that you can replicate the performance of hedge funds by simply selling 1-month at-the-money put options on the index every month and keeping your money in one-month bank deposits.

This put-writing strategy creates a nonlinear payoff structure where most months you make money from selling the put option and the interest earned on the bank deposit. But in months when the S&P 500 is down significantly, you lose a lot. It is the proverbial ‘picking up pennies in front of a steamroller’ strategy.

Let’s look at how this put-writing strategy has worked in the last decade. Luckily, I no longer need to run an Excel spreadsheet to simulate the returns of such a PutWrite strategy myself. The CBOE does that for me these days. The chart below shows the CBOE PutWrite Index together with the Bloomberg Global Hedge Fund Index. I also add the performance of the CBOE PutWrite Index after deducting 3% in annual fees. Notice something?

PutWrite strategies still closely resemble hedge fund returns

Source: Panmure Liberum, Bloomberg

Ten years after my original post hedge funds still act like a very complex machine to sell put options on the S&P 500. They do all kinds of sophisticated trades in listed and private markets but when all is said and done, it washes out. Indeed, the monthly correlation between the CBOE PutWrite Index and the Hedge Fund Index is 0.83.

And to close on a question I have been asked recently: Now that interest rates have normalised again, did hedge fund performance improve? The answer is no. If anything, the performance advantage of the PutWrite strategy over hedge funds increased.

PutWrite strategies vs. hedge funds after the pandemic

Source: Panmure Liberum, Bloomberg

Does that mean that all hedge funds are a waste of time and money? No. Individual hedge funds can create returns that differ significantly from this average hedge fund return. And if you identify a skilled hedge fund manager it is definitely worth investing in them to gain access to their unique skills.

But what definitely is a waste of time and money, in my view, is to invest in a ‘well diversified’ portfolio of hedge funds or in fund-of-funds. Yes, the people who sell you these ‘portfolios of hedge funds’ claim they can identify the skilled managers, but in reality, they can’t. Instead, what you get is a portfolio of funds where the unique features of single hedge funds wash out and you are left with the kind of average hedge fund performance shown above. In these cases, the only people who benefit from the investment are the managers and advisers who capture the fees but not the investors.