To the standard person, a hedge fund manager might be the first image that involves mind when considering of a quintessential Wall Street character: a suited guru shouting orders into the phone, brokering trades that make their clientele wealthy. But recently, reality paints a special picture. After a subpar 12 months in 2023, portfolio managers have been forced to shift strategies, with many turning to vanilla index funds to make up for poor performance.
Last 12 months was a bounce back for the broader market after a dismal 2022, but it surely surely was still not kind to hedge fund investors, who expect their money managers to provide returns that beat the market averages. In step with recent survey data from banking company BNP Paribas, hedge funds saw a return of 6.67% globally throughout 2023, 1.5% shy of their intended goal rate. Comparatively, the S&P 500 produced a 24% return last 12 months, allowing investors who embraced the easy strategy of investing in index funds to experience similar gains.
Consequently, lots of those hedge funds are altering their approaches and investing in index funds, which can be being driven by the continued success of enormous cap stocks. The trend exemplifies why many retail investors heed the long-touted adage of Warren Buffett: Index funds are one in every of the only ways for an investor to get stock market exposure. Hedge funds, it appears, are taking notice, too.
It won’t seem shocking that a portfolio manager turns to an investment that makes money — that’s their job. But hedge funds don’t typically dip into index funds. With their high fees, and thus high net value investors, these funds are typically involved in additional complicated strategies meant to beat the index funds that they are actually buying. This emerging reliance on index investing is a transparent sign that hedge funds are grasping for a life preserver.
Hedge funds are investing like index funds
Regardless of the state of the market, the primary goal of a hedge fund is to deliver positive returns to their typically high-net-worth clients. Nonetheless, in 2023, those returns fell well wanting what investors and fund managers hoped for, concurrently the important thing indices rebounded from 2022’s bear market.
Numerous the world’s largest and most reputable hedge funds, like Citadel’s Wellington fund or Sculptor’s Och-Ziff fund, saw returns in 2023 of 15.3% and 12.9%, respectively. While impressive as compared with the mixture, these funds sorely underperformed in comparison with the S&P 500 or the tech-heavy Nasdaq-100, which returned an eye-popping 55% throughout the identical time.
A way these hedge funds were able to rebound, though still falling wanting expectations, was through “index hugging” — when an actively-managed fund (like a hedge fund) invests more like an index to have the ability to enhance its returns.
Data from Goldman Sachs’ Hedge Fund Trend Monitor reveals that hedge funds are narrowing their underperformance to index funds by shifting their portfolio weighting much more heavily toward growth stocks, just like the “Magnificent 7” tech stocks that represent the largest holdings in numerous index–weighted portfolios. Of the greater than 700 hedge funds analyzed, nearly one in seven have Amazon, Microsoft and Meta amongst their 10 largest holdings.
Taking Warren Buffett’s advice
Warren Buffett is well-known for his opinion that the standard investor should purchase and proceed to accumulate investments in index funds. In 2020, Buffett said that “for most people, among the finest thing to do is to own the S&P 500 index fund, adding “People will try to sell you other things because there’s more money in it for them within the event that they do.”
This no-frills investment strategy might be the best for ensuring long-term, low-cost gains. Nonetheless, Buffett’s advice just isn’t necessarily meant for hedge funds but individual investors. In actual fact, there are multiple problems which arise from hedge funds hugging indexes for returns moderately than pursuing alpha (gains in excess of market benchmarks). Considered one in every of these is that many hedge funds look almost indistinguishable from one another as they crowd into the equivalent positions. This may need huge implications if the market were to shift for the more serious and folks funds were to act rashly in unison.
One other issue is that investors in these hedge funds won’t be getting the services they’re paying for. Hedge funds often require lofty service fees from their clients — typically a management fee of two% of the fund’s net asset value and a performance fee of 20% of the fund’s profits together with a minimum investment that typically starts at $100,000 but can range north of $1 million. These payments make hedge funds less accessible for average investors, but when funds are simply buying and holding what index funds are holding, then the people invested in them are paying way more for something that also underperforms the very indices they are trying to mimic.
Whether hedge funds could have the power to satisfy their overperformance expectations for 2024 is perhaps a matter of paring down on mega-cap investments and pivoting toward more dynamic strategies. But the large takeaway for the frequently investor is that Buffett’s advice still rings true in 2024; index funds provide considered some of the cost effective and most proven ways to take a position for long-term growth. Even the flamboyant hedge fund managers on Wall Street are embracing this concept, though they is perhaps quiet about it.
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