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Active vs. Passive vs. Hedge Funds

New York (HedgeCo.Net) – As the prominence of low-cost mutual funds and ETFs has grown over the last 30 to 40 years, so has the debate over whether passive management is better than active management heated up. Study after study has been conducted to argue the merits of each style of investment management. In most instances, the argument is that after fees, active management fails to outperform passive management.

Even though it certainly isn’t the case, many investors think of hedge funds as active management strategies. While there are certainly hedge funds that use an active management approach, there are others that lean toward the passive approach. More importantly, most of the funds used in these studies are mutual funds rather than hedge funds. Given that the studies have been conducted over time and are looking at different time periods throughout history, it is unlikely that the studies are using alternative mutual funds as part of the demographic, so it is highly likely that most of the funds being compared are long-only funds.

Comparing active management to passive management for long-only strategies is fine, but if you are going to compare active management long-only strategies to hedge fund strategies, you have to break the performance stats down in to different market cycles. From January 1, 1999 through December 31, 2009, the S&P lost 24.1%. If you were using a passive management strategy and held an S&P 500 mutual fund or ETF, your portfolio would have taken a 24% hit, give or take a few decimal places. Comparatively, the Credit Suisse Hedge Fund Index gained 89% from January 1, 1999 through December 31, 2009.

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Looking at the Credit Suisse Hedge Fund Index versus the S&P 500 from 2000 through 2009, you see how a $100,000 investment would have performed. While the hedge fund index nearly doubled, the S&P 500 had only partially recovered from the 50% drawdown it suffered in the bear market of 2007-2009.

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*Data courtesy of Credit Suisse Hedge Index

Active management with hedge fund strategies provided the answer during this time period, thus it is important to know whether the studies comparing active management and passive management are including bearish or hedging strategies. Active versus passive didn’t make much of a difference during the bear market of 2007-2009 if you were only using bullish strategies. If you were only using stocks and you were only using bullish strategies, there wasn’t any place to hide. The ten main sectors all saw signoficant losses in the bear market. The table below shows how the ten SPDR ETFs that represent the sectors performed during the bear market.

ETF Price on 9/17/07 Price on 3/2/2009 Percentage loss
Energy Select Sector SPDR (XLE) $72.65 $38.12 -47.53%
Consumer Staples Select Sector SPDR (XLP) $27.22 $19.97 -26.63%
Consumer Discretionary Select Sector SPDR (XLY) $36.42 $16.87 -53.68%
Technology Select Sector SPDR (XLK) $25.86 $13.78 -46.71%
Industrial Select Sector SPDR (XLI) $39.20 $15.98 -59.23%
Utilities Select Sector SPDR (XLU) $39.73 $24.55 -38.21%
Healthcare Select Sector SPDR (XLV) $34.68 $21.99 -36.59%
Materials Select Sector SPDR (XLB) $39.46 $18.08 -54.18%
iShares Dow Jones US Telecom (IYZ) $32.52 $14.38 -55.78%
Average sector loss for the period -49.74%
S&P 500 SPDR (SPY) $148.10 $70.60 -52.33%

With the numbers in the table in mind, if you were using a long-only bullish approach, where were you supposed to invest? Does it really matter if you were using active or passive management strategies? Not if you were only making bullish bets.

As alternative strategies gain in popularity, it will be interesting to see how the studies comparing active and passive management evolve. Platforms like HedgeCoVest and alternative mutual funds could and should facilitate changes in the studies.

The point is that there are different ways to make money investing. Some investors are better at the seeing the big picture and timing the overall market while others are better at the micro-picture and delving deep into one stock at a time. Regardless of which type of investor a fund manager is, if they don’t take action to protect the downside or if they can’t take action due to the funds structure, they will have a hard time making money in a bear market. Sure they may beat the S&P 500, but during the bear market referenced in the table above, you could have beat the market by only losing 50%. Is that what you are looking for out of a fund manager? Doubtful.

Hedge fund strategies and thus the models on the HedgeCoVest platform are looking for absolute returns, not returns that beat the market by a few percentage points during a flat or down market.

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