Vanguard Funds vs Hedge Funds (Guess Who Wins)

When you think Vanguard funds, what words and investing concepts come to mind? You might think accessibility, low-cost, simple, and average returns.

winnerslosers185How about hedge funds? They tend to have the opposite associations, such as high barriers to entry, high expenses, and above-average returns.

If you made all of the above assumptions, you’d be correct, with exception of the part about returns:

  • Accessibility: Vanguard funds typically have $3,000 minimum initial purchase amounts; hedge funds require investors to have high net worth, such as $1 million or higher.
  • Cost: Vanguard funds have an average expense ratio of 0.19%; hedge funds are often 10 times that at around 2% of assets plus a 20% cut of profits.
  • Returns: Vanguard funds are known for their passively-managed index funds that closely match the returns of major market indices, such as the S&P 500 Index, and hedge funds use leveraging strategies to chase positive returns.

But how do the returns compare? Are the higher fees of hedge funds justified by higher returns than that of Vanguard funds? Let’s take a look at some performance history and find out.

Vanguard Index Funds or Hedge Funds?

The average hedge fund rose 3% in 2014. Annualized returns have been 6.97% for the past five years 5.1% for the past 10 years, as reported by The Wall Street Journal.

Now compare that to a plain vanilla index fund, such as Vanguard 500 Index (MUTF:VFINX), which rose 13.5% in 2014 and averages 16% annualized for the past five years and 8% for each of the past 10 years.

To be fair, stocks have had an unusually strong 5-year run, and hedge funds are diversified to the degree that matching a 100% stock portfolio is not to be expected in such an environment.

So let’s be a bit fairer and compare one of the best and most boring of Vanguard balanced funds, Vanguard Balanced Index (MUTF:VBINX), with hedge fund performance.

In 2014, VBINX was up 9.8%, compared to the average hedge fund’s performance of just 3%. To capture a broader time period and a full market cycle in a comparison, the Vanguard Balanced Index fund’s 10-year annualized return is 7.3%, compared to 5.1% for hedge funds. A simple, low-cost balance of roughly 60% stocks and 40% bonds beats hedge funds!

Still, to give hedge funds some benefit of the doubt, they may show an investor their greatest value during a bear market, an environment in which you might expect a good hedge fund to minimize volatility and produce positive returns, or at least keep losses to the low single-digits, in a severe market correction for stocks, where prices fall more than 20%.

However, according to a Vanguard study on hedge funds during the Great Recession, where stocks took a nosedive from November 2007 through February 2009, a portfolio of 60% stocks and 40% bonds had a monthly return of -2.3%, whereas a fund of hedge funds index had a monthly return of -1.6%. That’s not much of a difference in volatility reduction for the added cost of hedge funds.

Hedge funds lose the long-term (and often the short-term performance) race. Stick with Vanguard funds.

As of this writing, Kent Thune did not hold a position in any of the aforementioned securities, although his firm holds several Vanguard Funds in client accounts. Under no circumstances does this information represent a recommendation to buy or sell securities.

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