The Tragedy of the "Smart" Money

Imagine a PGA Tour where the average player is no better at golf than the viewers at home. Or an NBA where most players never make a basket throughout their careers. Or a NASCAR where most drivers can't top the 65 mph speed limit of public freeways.

You'd be insulted and would never pay attention to these "pros." But this is essentially what the universe of professional hedge fund managers looks like.

The average hedge fund is up 2.15% year to date, according to Hedge Fund Research. A basic S&P 500 (INDEX: ^GSPC) index fund gained 12.5% during that time. That isn't a fluke, either:

Source: Hedge Fund Research; Robert Shiller; author's calculations. Dividends reinvested for S&P 500.

A thousand dollars invested in HFR's group of global hedge funds in 2005 would be worth $997 today, while the same amount invested in a simple S&P 500 index fund would be worth $1,346. This is comparable to a group of NBA teams playing a local high-school basketball team for seven years straight and scoring a third fewer points. It's impressively bad.

To be fair, the S&P 500 might not be the best benchmark for global hedge funds, which dabble in bonds, derivatives, real estate, and even fine art. But the rationale for measuring hedge funds against an alternative benchmark -- that is, they focus on "absolute" returns that perform in any market environment, rather than "relative" returns against the crowd -- fades when the industry has lost money in two of the last seven years. There is no way to rationalize hedge funds' recent returns. Professional investors, many with Ph.D.s and decades of experience, tend to underperform your grandmother's passive index fund. That's reality.

Of course, hedge funds can be measured as a group, but there are individual standouts. John Paulson and Kyle Bass bet against the housing bubble and made fortunes. David Tepper bet on bank stocks and made several billion dollars. Ray Dalio has emerged as one of the best investors of all time. These investors are true stars, but they are also true exceptions. In aggregate, professional hedge fund managers severely lag the market.

Why?

To start, the hedge fund industry has grown so large that it's nearly impossible to outperform as a group. With $2.3 trillion under management -- up 11-fold in the last 15 years -- hedge funds struggle to beat the market because they effectively are the market.

Then add in nosebleed fees. The typical hedge fund charges a 2% annual "management" fee off the top, plus 20% of profits. These fees may be justified for a handful of exceptional funds. But the exception has become the norm, and market-lagging funds now charge fees totally inconsistent with performance. Blogger Josh Brown was once asked what a hedge fund is. He replied, "A vehicle that turns investor capital into Greenwich real estate."One Fool commenter quipped that if pay were fair, most money managers would receive a bill at the end of the year, rather than a paycheck.

There is progress here as investors stomp their feet and demand that fees be reined in. But there's a long way to go -- and as long as an index fund charges total fees of 0.06% a year and trounces most hedge funds, there will continue to be.

A third limiting factor is a culture of "short-termism." Most hedge funds are measured quarterly, but stories abound of investors demanding monthly, weekly, and even daily trading reports. That creates all kinds of distortions. When you are measured by short-term performance, you manage for short-term performance, which means forgoing long-term opportunities.

The big takeaway, as Warren Buffett says, is that "Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ." Many hedge fund managers are truly brilliant. But the market doesn't care how many Ivy League degrees you have, how complex your model is, or how you did on the SATs. Successful investing is mostly about having control over your emotions. That's why the index fund, which knows no emotion, tends to win.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

The article The Tragedy of the "Smart" Money originally appeared on Fool.com.

Fool contributor Morgan Housel has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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