Don’t Blame Hedge Fund Managers

Hollywood loves the story that hedge fund managers are taking advantage of the little guy simply trying to earn a fair rate of return. Like most liberals, Hollywood screen writers are frequently wrong but seldom in doubt.

Consider the U.S. stock market of a little over 3,500 listed stocks[1]. Stock investors can be divided into three types:

  • Investors who tend to earn above average returns,
  • Investors who tend to earn average returns, and
  • Investors who tend to earn below average returns.

Here’s the key: Every investor can easily lock in average performance by buying and holding a passive index mutual fund on the whole U.S. stock market. These investors are called “Passive Investors” while hedge fund managers and stock pickers are called “Active Investors”.

Passive investors can select from a variety of index mutual funds to earn the total market’s return with almost no fees or other expenses. Fidelity has issued a fund (ticker symbol FZROX) that has a zero expense ratio!

Schwab, Vanguard and other institutions offer total market funds with expense ratios of less than five basis points per year. So an investor placing $100,000 of retirement money in these funds will pay less than $50 per year in fund fees and other expenses!

To the passive indexer, it doesn’t matter whether hedge fund managers are beating the market using inside information. It’s like betting on every square on a roulette table: it doesn’t matter whether the wheel is crooked or whether other gamblers are clairvoyant![2]

Let’s say that in a particular year the stock market generates a 5% total return (including dividends). How will our two types of investors fair? The passive indexers will earn 5% (ignoring the minor fund fees).

Note that if the whole market generated a 5% return, and if passive indexers as a group earn 5% before fees, then the active investors as a group must also – on average – received 5% before fees. We know this because there are only two groups (active and passive).

Within the group of indexers every indexer gets the same return of 5%. But although the active investors earned an average of 5% before fees, some active investors earn way more than 5% and some earn way less than 5% based on skill (or lack of skill) or luck (or bad luck). Note that active investors take higher risks than passive investors and as a group they receive no increase in expected return. Further, the active investors as a group earn less than passive investors because they typically have substantially higher expenses than the passive investors.

So being an active investor means more risk and less average return. When anyone claims that the stock market is rigged and that hedge fund managers are getting rich off of the little guy it is only true when the little guy is also an active investor (who is trying to beat the average).

So winning active traders make their high returns from losing active investors. It is kind of like a poker game: there are winners, there are losers and there are people who do not bet. Nobody has to play poker and most people should avoid playing poker for money. Similarly, most investors should simply buy and hold passive index funds.

But there is more to the story. Active investors such as hedge fund managers provide three tremendous services to a society: (1) They provide liquidity that allows all of us to contribute and withdraw from our funds, (2) they help ensure that the overall price levels of markets and prices of individual stocks tend towards being rational, and (3) they push prices towards levels that signal vitally important and continuously-updated information on the economy to its participants.

I do not feel sorry for those who play poker and lose. And I do not think any of us should feel sorry for those who chose to try to beat the stock market rather than passively index. Liberals searching for evil capitalist exploiters should look elsewhere – such as when liberals get government to bestow special privileges on their cronies.

[1] This commentary focuses only on publicly-traded securities. Unlisted securities such as private equity are a different story. Unfortunately, regulation is driving more and more firms away from stock exchanges. Despite enormous growth in the U.S. economy, a few decades ago there were almost twice as many publicly traded stocks as there are today.

[2] This example ignores the “house take”, for simplicity.