How to Build Your Own “Hedge Fund”

June 02, 2016

Hedge funds have long been considered the sexiest investments. Part of it is that they’re exclusive, legally limited to “accredited investors” and financially limited to those who can afford their high fees (typically a management fee of 1-2% plus about 20% of the fund’s performance). They’re also the largely unregulated bad boy of the financially world, which allows them to use complex investments and strategies to try to outperform or hedge against the market for higher returns and/or lower risk.

I’ve always been skeptical of hedge funds though, so I was interested to read an article titled “Hedging on the Case Against Hedge Funds.” It defends hedge funds from a lot of criticism they’ve been getting lately for charging those high fees while producing disappointing performance numbers. (For example, Warren Buffett is on track to win a $1 million bet that a simple S&P 500 index fund would beat a group of top hedge funds over 10 years.)

The article makes the case that hedge funds can’t be expected to always outperform the stock market when stocks are doing particularly well. After all, many hedge funds are designed to “hedge” against the market so while they may not do as well when stocks are up, they should do better when stocks are down. But the article still ends up arguing that hedge fund fees are too high and that they perform too similarly to the stock market rather than acting as a true hedge. Fortunately, there are ways to get that type of hedging without paying such high fees.

For example, one strategy is the “permanent portfolio,” described by the late investment author Harry Browne in his book Fail Safe Investing. The concept is to divide your money with 25% each to stocks, long term government bonds, gold, and cash. The idea is that since stocks tend to do best during prosperity, long term government bonds during deflationary recessions, gold during periods of rising inflation (which can be bad for both stocks and bonds), and cash during “tight money” recessions when all the others may lose value, part of the portfolio should always be doing okay no matter what the economy is doing. By periodically re-balancing, you would sell some of the best performing investments while they’re priced relatively high and buy more of the worst performing ones while they’re priced relatively low. This can reduce your risk and increase your returns.

The numbers speak for themselves. From the year the book was published in 1999 to 2015, the permanent portfolio earned a 6.13% compound annualized return compared to 5.76% for a traditional 60/40 stock/bond allocation and 4.89% for the S&P 500. More impressively, the permanent portfolio’s worst year was a loss of only -3% vs. -20% for the traditional portfolio and -37% for the S&P 500.

Unlike the high fees charged by hedge funds and other active managers, the portfolio can also be created with a mix of low cost index funds. The value of this shouldn’t be overlooked. A study comparing the model portfolio allocations of various financial institutions found that the difference in returns between the best performing portfolio (9.72%) and the worst (9.19%) from 1973-2015 was about half a percentage point. Since the average active stock fund charges .86% in expenses and the average stock index fund charges .11%, going from index to active funds could have turned the best performing portfolio allocation into the worst! (And no, active funds don’t generally make up for their higher fees with higher performance.)

So does this mean you should invest in the permanent portfolio? Not necessarily. You just need to make sure your portfolio is broadly diversified beyond the stock market (including more conservative investments like government bonds and cash and real assets like gold or real estate) and has low costs. If you do that, there’s a good chance you’ll actually outperform most hedge funds. Your portfolio may not be as sexy but you can take it home to mom and dad.