What Percentage of Hedge Funds Beat the Market?

Hedge funds aim to generate significant returns for clients, often seeking to “beat the market” by achieving returns higher than benchmarks like the S&P 500 index. Employing diverse and complex strategies, many believe these specialized funds can outperform traditional investments. This article explores hedge fund performance against market benchmarks, examining the data and influencing factors.

Hedge Fund Performance Data

Hedge fund performance, measured net of fees, often lags broader market indices. From 2011 to 2020, the S&P 500 index delivered an average annual return of 14.4%, outpacing the average hedge fund’s 5.0%. Over a broader period (January 1994 to March 2021), the S&P 500 generated returns 222% higher than the average hedge fund. The Credit Suisse Hedge Fund Index has also historically lagged the S&P 500, averaging 7.02% compared to the S&P 500’s 9.83% since January 1994.

Research on actively managed U.S. equity funds, a category that includes many hedge funds, shows a majority underperform the S&P 500 over longer timeframes. For instance, 71% underperformed over one year, 93% over five years, and 98% over ten years. While the average hedge fund often underperforms the market in absolute returns, they typically exhibit lower volatility. The S&P 500 had a volatility of about 14.9% compared to roughly 6.79% for hedge funds between 1994 and 2021.

Despite the general trend of underperformance by the average hedge fund, some industry segments have shown stronger results. The HFRI Fund Weighted Composite Index has outperformed most liquid asset classes, except the S&P 500, over the past five years. A select group of top-performing hedge funds has outpaced the S&P 500. Research indicates the top 50 hedge funds collectively outperformed the market by over three percentage points over the trailing five years through 2022, achieving this with considerably less risk. Certain strategies, such as event-driven and equity hedge, also showed strong performance in 2023 and early 2024.

Challenges in Outperforming the Market

Achieving consistent outperformance against market benchmarks presents challenges for hedge funds, largely due to their operational structure and the nature of financial markets. The fee structure is a primary factor. Hedge funds typically charge both a management fee and a performance fee, often referred to as the “2 and 20” model. This means investors pay an annual management fee of about 2% of assets under management, plus a performance fee of roughly 20% of any profits generated.

These fees can erode investor returns. Research indicates that over the past two decades, hedge fund clients have seen more than half of their gross profits consumed by fees. This model makes it difficult for a fund to deliver net returns surpassing market indices, as a significant portion of gross gains is paid in fees. Even if a fund generates strong gross returns, the high fee structure can translate into modest or even negative net returns for investors.

Another challenge stems from the increasing efficiency of financial markets. As information becomes widely available, it is harder for skilled managers to identify mispriced assets that can generate excess returns. In efficient markets, prices quickly reflect all available information, limiting opportunities for active management to gain a sustained advantage. While hedging strategies mitigate risk and protect capital during market downturns, they can also limit upside participation in strong bull markets. By reducing exposure to market fluctuations, hedging can cap potential gains, which may lead to underperformance relative to a rising market index that benefits from full market exposure.

Implications for Investors

The performance data of hedge funds carries implications for individual investors constructing their portfolios. The consistent underperformance of the average hedge fund against broad market indices, particularly over longer periods, reinforces the argument for low-cost, passive investment strategies. Investing in broad market index funds or exchange-traded funds (ETFs) offers exposure to market returns at a fraction of the cost associated with actively managed funds, including hedge funds. This difference in fees can compound significantly over time, leading to substantial disparities in net returns.

Understanding the impact of costs is important for long-term investment success. The high management and performance fees charged by hedge funds demonstrate how costs can diminish overall returns, regardless of a fund’s gross performance. Investors should prioritize cost-consciousness in their investment decisions, opting for vehicles with lower expense ratios to maximize their potential net gains. This approach aligns with the principle that while investment returns are uncertain, fees are a guaranteed deduction.

Finally, the insights from hedge fund performance highlight the importance of setting realistic expectations for investment returns. Consistently beating the market is a difficult endeavor, even for experienced professionals managing sophisticated strategies. For the average investor, attempting to achieve market-beating returns through complex or high-fee active management may not be the most effective strategy. A diversified portfolio, built with low-cost index funds and managed with a long-term perspective, often provides a more reliable path toward achieving financial goals.