GMO beta Nov11.pngWarren Buffett is the world’s most successful investor, earning $62bn from his investments by 2009. But if he had instead channelled this money through hedge funds, and still been equally successful, he would have ended up with just $5bn. They would have taken the other $57bn.

Hedge funds have thus been the most successful way in recent years of parting investors from their cash. The concept was that they would earn their vast fees (normally 2%/year and 20% of gains) by making money in up and down markets.

This, of course, was an easy game to play when the Western BabyBoomers (those born between 1946-70) were all in their peak consumption and savings years. Markets boomed then, as described in chapter 2 of the new ‘Boom, Gloom and the New Normal’ free eBook.

But as the chart above shows, life has been more difficult over the past decade. It comes from the GMO investment fund, and looks at the relative performance since 1996 of three types of portfolio:

• Those holding very volatile stocks, “high beta” (yellow line)
• Those holder ‘safer’, less volatile stocks, “low beta” (blue)
• Those holding the entire universe of stocks (red)

Unsurprisingly, the high beta stocks held by many hedge funds did very well until 2000, when the Boomers began to leave the peak consumption 25-54 age group. Since then, they have underperformed quite badly. Overall, they have earned just 3.8% annually since 1996 – much less than the steady 6.8% of the low beta stocks.

Or, as GMO put it, “remarkably, an asset class that purports to be an ‘alternative’ source of returns, with low correlation to equity markets, turns out to be simply another way to take downside equity market risk….once fees are taken into account, hedge funds appear to offer nothing beyond a way to sell insurance against sharp market declines“.

Blog readers whose pension funds invest in hedge funds may have cause to remember this conclusion when they examine their next statement.