By Mark Hulbert
Hedge-fund alternatives aren’t the market diversifiers you’d expect
Don’t look to hedge funds to rescue your portfolio from the mediocre returns that stocks and bonds are likely to produce over the next several years.
As I’ve written repeatedly in recent months, the U.S. stock market is extremely overvalued, with an expected return over the next decade that is well below the rate of inflation. Bonds also appear to be unattractive, given the increasing likelihood that inflation will remain higher for longer.
Hedge funds would seem to be the answer. They specialize in opportunistically moving between various asset classes. In theory, they should easily outperform both stocks and bonds.
Unfortunately, the typical hedge fund’s track record shows otherwise.
Last year was a case in point. The traditional balanced portfolio that allocates 60% to stocks and 40% to bonds produced a 14.7% return (assuming the stock portion was invested in a broad U.S. stock market index fund and the bond portion was invested in a total U.S. bond market index fund). That’s nearly double the 7.4% return of the Eurekahedge Asset Weighted Index, which is described by Eurekahedge as its “flagship asset weighted index” of 1,438 constituent funds. This index, Eurekahedge adds, is “designed to provide a representative capital weighted benchmark for the entire global hedge fund industry.”
The index does represent an average of many funds, some of which did much better than average. But these outliers were not known in advance. We know that because of the performance of the Eurekahedge Fund of Funds Index, which “is designed to provide a broad measure of the performance of underlying investment managers who exclusively invest in single manager hedge funds.”
These funds of hedge funds employ analysts who scrutinize hedge-fund track records in hopes of identifying those that “should” become superior performers. Yet, as you can see from the chart above, the Eurekahedge Fund of Funds index did only marginally better in 2024 than the Eurekahedge Asset Weighted Index (gaining 9.7% versus 7.4%, respectively), and still significantly lagged behind the 60/40 portfolio. The chart also shows that last year was not an exception. Each of the Eurekahedge indexes lagged behind the 60/40 portfolio over the trailing five- and 10-year periods as well.
These results bring to mind the explosive conclusion reached by Richard Ennis, a former editor of the Financial Analysts Journal and co-founder of EnnisKnupp, one of the industry’s first investment consultants. In an article published in the Journal of Investing in February 2024, Ennis analyzed the impact of alternative investments, or “alts.” This category includes all asset classes other than stocks and bonds, such as “private equity, private market real estate, [and] hedge funds.”
After analyzing the performance of endowments and other large institutional investors, Ennis concluded: “Alpha [the difference between a portfolio’s return and its benchmark] appears to respond to the presence of alts as if the latter were kryptonite – the greater the exposure, the harsher the effect on alpha.”
AI to the rescue?
Hope springs eternal. And for many hedge fund aficionados, that means the promise of artificial intelligence. But this hope rests on shaky ground.
Consider the performance of the Eurekahedge AI Hedge Fund Index, which is “designed to provide a broad measure of the performance of underlying hedge fund managers who utilize artificial intelligence and machine learning theory in their trading processes.” This index has done even worse than its two broader Eurekahedge index siblings, producing annualized returns of 1.9%, 3.5% annualized and 5.5% annualized over the past one-, five- and 10-year periods, respectively.
Hedge funds are more closely tied to the stock and bond markets than most recognize. We know this because of the correlation coefficient of hedge-fund returns and those of the 60/40 portfolio. The correlation coefficient of monthly returns of the Eurekahedge Asset Weighted Index and the 60/40y portfolio is 74%; with the Eurekahedge Fund of Funds Index, the coefficient is 72%.
In presenting these sobering statistics, I am not suggesting that the 60/40 portfolio will necessarily perform well in the coming years. Expected returns for both stocks and bonds are mediocre. My point is that, regardless of how stocks and bonds perform, it’s unlikely that the typical hedge fund or even fund of hedge funds will do better than a 60/40 portfolio.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
More: Is this time different? How to invest as the ‘Magnificent Seven’ lose momentum.
Plus: Hot CPI reignites stagflation fears. Here’s why that would be disastrous for your 401(k).
-Mark Hulbert
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