The Dumbest Idea In Finance: A Diversified Hedge Fund Portfolio

Modern financial theory holds that a diversified portfolio of securities is the most efficient way for an investor to access an asset class. Idiosyncratic risk, the risk associated with an individual stock say, can be diversified away and therefore theory holds that investors don't achieve any additional return for holding concentrated portfolios of their favorite stocks. It's an idea that makes a lot of intuitive sense. Consequently, you can invest in equities and possess no particular stock-picking skill by using an index fund. Hundreds of billions of dollars are invested passively in this way. Based on many decades of performance from public equities (although admittedly the last decade was no walk in the park) this is a sound strategy.

Using the same construct with hedge funds produces a different result. A key underlying assumption in the "diversification is good" approach is that the underlying asset class has a positive return. However, as I show in my book The Hedge Fund Mirage, if all the money ever invested in hedge funds had been in treasury bills instead, the investors would have been better off. The average hedge fund $ generated a negative return with respect to the risk-free rate. There are great hedge funds and happy clients, but these are not the norm. Since I wrote my book hedge funds have continued to provide empirical support for my findings. YTD performance for the HFRX Global Hedge Fund Index is 1.2% through June - actually outpacing treasury bills (which yield approximately 0%) but for the tenth straight year lagging a simple 60/40 stocks/bonds portfolio.

Since hedge funds in aggregate have been a bad investment, the only way to win as an investor is to be better than average at picking managers. Some people are. But….

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