This is How a Cheap Balanced Portfolio Flattens Those Pricey Hedge Funds

If you're hoping hedge funds will provide a strong alternative to stocks and bonds amid expectations of lackluster returns in the coming years, you may be disappointed.

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The U.S. stock market remains significantly overvalued, and its expected returns over the next decade are projected to fall below inflation. Bonds, meanwhile, seem equally unappealing due to the increasing likelihood of persistently high inflation.

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Hedge funds, in theory, should offer a solution. By dynamically shifting between asset classes, they have the potential to outperform both stocks and bonds. However, historical performance suggests otherwise.

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Take last year as an example. A traditional 60/40 portfolio—where 60% is invested in a broad U.S. stock market index fund and 40% in a total U.S. bond market index fund—delivered a 14.7% return.

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By contrast, the Eurekahedge Asset Weighted Index, which tracks the performance of 1,438 hedge funds worldwide, returned just 7.4%. Despite being a representative benchmark for the global hedge fund industry, this index fell far short of a simple stock-and-bond allocation.

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It’s worth noting that some individual hedge funds performed well. However, identifying these high performers in advance is nearly impossible. This is evident from the results of the Eurekahedge Fund of Funds Index, which tracks the performance of funds that invest exclusively in hedge funds.

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These funds employ analysts to carefully select hedge funds they believe will outperform. Yet, in 2024, this index returned only 9.7%, slightly better than the general hedge fund index but still well below the 60/40 portfolio. Over longer timeframes—five and ten years—both Eurekahedge indexes have consistently lagged behind the traditional 60/40 approach.

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These findings align with research conducted by Richard Ennis, a veteran investment consultant and former editor of the Financial Analysts Journal. In a February 2024 article for the Journal of Investing, Ennis examined the impact of alternative investments—such as hedge funds, private equity, and private market real estate—on institutional portfolios.

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His conclusion was striking: greater exposure to alternatives tended to drag down performance rather than enhance it. He likened their effect on returns to “kryptonite.”

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Despite this discouraging track record, some hedge fund advocates remain optimistic, particularly about artificial intelligence. AI-driven investment strategies promise to uncover hidden market opportunities, but their real-world results have been underwhelming.

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The Eurekahedge AI Hedge Fund Index, which tracks funds that use AI and machine learning in trading, has posted disappointing annualized returns—just 1.9% over the past year, 3.5% over the last five years, and 5.5% over the last ten years. These figures suggest that AI-driven hedge funds have struggled even more than traditional ones.

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One reason for hedge funds’ persistent underperformance is their close correlation with stocks and bonds. The monthly returns of the Eurekahedge Asset Weighted Index and the 60/40 portfolio have a correlation coefficient of 74%.

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The Eurekahedge Fund of Funds Index is similarly tied to the stock-and-bond mix, with a correlation of 72%. This means hedge funds are not as independent from traditional markets as many investors assume.

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None of this is to say that the 60/40 portfolio will necessarily perform well in the coming years. Stocks and bonds are both facing challenging conditions, and expected returns remain modest. However, hedge funds—despite their complex strategies and high fees—are unlikely to offer a superior alternative.

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