Daily Gains Letter

One Simple Strategy for Outperforming Hedge Funds

By for Daily Gains Letter |

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There’s often a debate among Main Street investors that institutional investors—more specifically, hedge funds—can provide better returns compared to managing the money by themselves. The main reason for this is that institutional investors have resources: for example, access to data, the ability to perform in-depth analysis, and so on and so forth.

Last year was a good year for equities. The key stock indices like the S&P 500, the Dow Jones Industrial Average, and the NASDAQ Composite index registered gains between seven percent and 13%.

In the same time, according to Hedge Fund Research, Inc., hedge funds posted an average gain of only 6.2% in 2012. (Source: Farrell, M., “Hedge funds say good riddance to 2012,” CNN Money, January 14, 2013.)

Some of the well-known hedge funds underperform the performance of the key stock indices. Consider the Advantage Fund, managed by John Paulson. This fund posted a loss of 14% in 2012, and in 2011, it was down 35%.

Now, the question: are institutional investors right? Is it a good idea to invest with them rather than manage your own money?

Even though the average return from hedge funds was a little more than six percent below the overall market performance, it doesn’t mean the entire fund underperformed. At the end of the day, it’s an average. Certainly, there were funds that did much better than the average. Consider Third Point LLC, managed by Daniel Loeb; this hedge fund provided gains of 21.2% to its investors.

So, saying all institutional investors are right or wrong may not be the best judgment call. What it really boils down to are the market conditions and the investing style of the fund manager; just like companies, institutional investors can be wrong and not perform as anticipated.

How can an individual investor beat the markets, then?

To invest in hedge funds, investors need to meet certain requirements, which the average investor with a fairly small portfolio may not be able to do. However, thanks to financial innovation and the introduction of investment instruments like exchange-traded funds (ETFs), investors can invest in hedge funds with billions of dollars under management—and they may be able to beat the fund’s performance.

Going back to the performance of hedge funds in 2012, if investors invested their money into the SPDR S&P 500 (NYSEArca/SPY) ETF, their returns would be very close to the return of the S&P 500, and much higher than the average hedge fund return of 6.2%, even after expenses.

With all this said, investors need to make sure they are aware of the current economic conditions and what to expect—they need to consider changes in the economy and where the next move will be.

For example, key stock indices provided better returns, but the housing market in the U.S. economy showed some significant movement. Consider the SPDR S&P Homebuilders (NYSEArca/XHB) ETF. This ETF holds companies that are involved in the housing market in the U.S. economy. During 2012, when hedge funds posted gains of 6.2% and the S&P 500 gained 13%, this ETF increased more than 50%, from $17.20 to $25.85.

In pursuit of growing your portfolio over time, you don’t necessarily have to invest in hedge funds or give money to someone else to manage—you can do it by yourself. Just by knowing what’s happening in the economy, you can reap the rewards.

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