Why Index Funds Often Outperform Hedge Funds

The desire to have enough money to invest in hedge funds is a dream that’s shared by many. However, an often-overlooked fact is that hedge funds frequently underperform index funds—which are far less risky and much easier to understand. Having access to a multitude of investments, coupled with great flexibility and sophistication, sounds excellent on the surface. But that’s not always the case.

There are a number of good reasons to stick to index funds, thus hedge funds present some disadvantages:

Hedge funds have very high fees

Out of all the people that invest in hedge funds, only one group consistently makes money from them: hedge fund managers. Despite their names, hedge funds aren’t hedges at all, since investors can lose as much money as they put in. One standard fee for hedge fund management is 2% of the total amount invested plus 20% of any profits.

And since nearly the only way to make real money from a hedge fund is for it to make lots of money, investors are effectively paying their managers to make lots of money from their own investments.

  • Hedge fund managers are often billionaires because they make enough money to invest in their own funds.
  • Due to the fact that it is almost impossible to make money back when you are only 2% behind, 2% is often considered to be a hurdle that needs to be overcome. A loss of 20% is a significant setback, and can thus be considered a burden by some.
  • Consider keeping your money in passive, index-tracking funds, which have fees under 0.2%. They’ll do all the work of picking a portfolio for you, without meddling in your profits.

Hedge funds have become too big

While index funds have grown to the point where they cover over sixty percent of total market assets under management, this is actually a good thing. While many hedge funds have grown too big to take advantage of lucrative opportunities, when an opportunity presents itself, index funds can jump into a position and obtain the best return.

Hedge funds are compelled to invest in lower-quality investments. As hedge funds get bigger, it becomes more challenging to generate strong returns. Warren Buffett has said he could earn 100% per year on a million dollars. But, investing several billion dollars can be limiting.

The market is very efficient

The fact that every piece of information available to investors has already been factored into each stock price means it’s impossible to beat the market.

Obviously, the market isn’t 100% efficient. Indeed, there are investors that regularly outperform the market with far less risk. But it’s very challenging to be consistently successful. As for the extra 2% fee hedge fund investors are paying—to make up for that, they have to beat the market by more than 2%. That doesn’t even take into account the 20% profit scrape, which is taken off the top every year by investment banks.

To outpace the market, a hedge fund manager has to outperform the market by a considerable amount.

When hedge funds lose money, they can lose a lot

Hedge funds take on a high level of risk, and hedge fund managers love risk. They’re already guaranteed 2% of the money they manage; any profits greatly increase their income. A high level of risk is also necessary to overcome the fee structure and provide high returns to investors.

  • The ratio of risk to reward is quite high—the higher, the greater the risk.
  • Hedge funds often use margin accounts and short selling, a tactic that one financier described as “betting against their own customers.”

Low liquidity makes it difficult for the investor to get out quickly

If your future is dim, it can be hard to get your money out of a product that doesn’t work. It may be months before you can pull out the cash and see how much of it you still have.

Index funds have too many advantages

Index funds are a solid substitute for hedge funds. They offer what hedge funds can’t—low fees, low risk and market-matching returns.

Index funds, though ostensibly lower-class citizens than hedge funds have many advantages over their richer and more powerful betters. Index funds have cheaper entry fees and lower minimum investment amounts; hedge funds are unable to consistently beat the market on a regular basis, and even hedge fund investors themselves often earn less money on the investments than the hedge fund managers take in compensation. Though an index fund may not be the best choice for everyone, in most cases it is an excellent investment for most investors.


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