After five years of failure, hedge funds are beating the stock market again

What’s down is up.
What’s down is up.
Image: Reuters/Regis Duvignau
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Over the past one, three, and five years, hedge funds have underperformed the overall stock market, providing 53-73% of the returns over those periods. Not anymore.

Despite the prevailing wisdom that it isn’t possible to beat the market, hedge funds are outperforming at the moment. The US stock market has had a rough start to the year, with the benchmark S&P 500 down 0.39%, but hedge funds have provided investors with 0.82% gains this year, according to the HFRI Equity Hedge Index.

This shouldn’t be surprising: Hedge funds are supposed to outperform in down markets. At the most basic level, hedge funds are by definition hedged with bets for and against stocks rising. Those hedges mean that they should, on average, underperform when the stock market is going up (since they have bets against the market) and outperform when the market is going down (since, again, they have bets against the market).

To better illustrate the upsides and downsides of hedging, let’s look at tech stocks, which have powered the last few years of growth in stocks and continue to outperform other sectors since stocks started to go sideways earlier this year.

While hedge funds are outperforming the overall market this year, tech-specific hedge funds—many of which are also shorting tech companies as well as betting on them to grow—are underperforming the tech sector. So, while the S&P 500 Tech Index is up 8.25% this year, the HFRI Technology Index is up only 4.41%.

If 2018 continues to be a rocky year in the stock market, it may be that active stock pickers at hedge funds finally get their day in the sun, providing their investors with some downside protection once the nearly decade-long stock market party winds down.