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Tangential nitpick because this always really grinds my gears when I see it...
The index funds versus hedge funds comparison is insanely dishonest. Warren Buffett started it decades ago and it's an argumentative sleight-of-hand.
Broad market index funds (anywhere from 100% equity allocation to the 60/40-bond mix) pretty much track "the economy" as a whole. You're betting on all of the horses. Across cap size, across sectors. If you're including bonds, then you're covering the two largest asset classes on earth. If you can stay in the market long enough and tolerate bouts of down years, you're going to do just fine because the "oh shit" scenario is literally a 20-40 year sustained depression for the United States and very probably the rest of the world. Which, if it happens, fucks everyone including hedge funds and techBros. For generations.
Hedge funds are always much more narrowly constrained in what they invest in, and they often target very specific return profiles. "We long/short large cap non-financial equities and forecast capturing 80% of broad market upside in outperformance years while avoiding draw downs of over 20% in down years, with high annual liquidity but low turnover." That's contraint-on-constraint-on-constraint that index funds don't have to deal with at all. And hedge funds call their shots in that they predict a return profile within a given timeframe and aren't allowed to take excessive risk or leverage to get there. They actually can't "bet it all on black" again and again. Simply allocating to a portfolio with too elevated risk metrics constitutes something close to a breach of contract.
Why do hedge funds do this? Because most of them are trying to appeal to institutional investors (retirement funds, university endowments, etc.) that have really specific needs for performance, risk management, and cash disbursements for every single year. If you're CALPERS and you need to - every single year - push out $10 billion of retirement cash to your members to avoid a massive class action lawsuit, you need to find a hedge fund that has a reasonable chance of delivering part of that return profile. And they have to (try to) guarantee (part) of that return no matter what the rest of the market does. If there's a bad year, neither the hedge fund nor CALPERS can say, "Hey, sorry, we'll just wait a couple years to get back even." Nope, those retirees want their cash on the first of the month no matter what - and they probably have the legal language to back it up.
Why only part of the total return? Because no large institutional investor is allowed to give all of its money to a single fund / general partner. Diversification is always (nowadays) written into their charters. So, maybe the first chunk of money goes to the hypothetical fund above. That means that anybody else who's doing long/short in large cap non-fin equities is automatically off the list to receive another chunk of the institution's money - there's too much correlated risk. Pretty soon, you're investing in ARK Innovation because it's the only fund left who can take $100m - $1bn [:1] of capital that doesn't look like it's correlated to the rest of your portfolio.
Hedge funds are providing a very precise service at scale to a clientele that needs that precision within a time bound box. Index funds are providing general returns that track an economy over large cycles. It's pretty close to the difference between looking for a general practitioner doctor for health advice ("diet, exercise") and looking for a brain surgeon with tumor removal expertise that can also guarantee your blood pressure won't spike and your body temp won't fall too low during the surgery. Yep, that second guy probably has more dead patients on him, but that first guy has mustard on his shirt and likes to watch Mad Money in the afternoons.
[:1] Another thing people like to point to is that smaller funds often outperform their larger peers. That's because you have way more flexibility as a smaller fund and it's easier to deploy smaller amounts of capital. Big funds are a special monster because there are only so many things you can plow $1bn into and NOT move the market on your own.
The idea of the bond allocation is that bonds tend to do well relative to stocks when the economy is not doing so well, like in 2008 or 2001-2002. The problem is this failed massively in 2022.
Hmm but there have been many notable hedge fund failures of supposedly safe strategies, notably the collapse of LTCM.
"The market can remain irrational longer than you can remain solvent." That's LTCM in a nutshell.
There's no such thing as an omni-safe investment. What you have in the strategies employed by firms like LTCM are situations that, when identified, have a very high if not perfect chance of doing exactly one thing eventually.
LTCM modeled spread convergences. You can look up the mechanics on your own. The problem is that in order to take advantage of this strategy, LTCM had to pay what amounted to insurance payments until the spread did, in fact, converge. The longer that doesn't happen, the more you pay. And if you're liquid capital dries up, sucks to be you - even if you turn out to be right! Additionally, LTCM eventually succumbed to the attraction of using leverage when the spreads themselves started too narrow. Leverage amplifes both returns and losses so if the spreads stopped narrowing and widened, even just a bit, LTCM would potentially be blown up - which is what happened during the 90s Russian debt crisis.
All of this is to say that even the risk-free rate of return (most often 10yr or longer Treasury Bonds) isn't static and isn't actually risk free if you layer it with leverage, derivatives, etc.
In terms of hedge funds "calling their shots" - I didn't mean to imply hedge funds sell "safe" strategies or that they always hit their anticipated performance. This is actually one of the brutal realities of the industry - if you're a senior analyst or a portfolio manager and you miss your targets even for one year, there's a really, really good chance you will get fired and, at best, only be able to find a new job a step down from where you were. While hedge fund compensation is pretty insane, it's a lot like professional sports in that you might only make it for 3,5,10 years before being close to unemployable. A lot of blowout types tumble down to financial consulting or fair valuation opinions or just market analysis and equity research. Still (mid to high) six figure jobs, but a far cry from some of the 7/8/9 (it happens) figure payouts people see in single years.
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