What's up guys and welcome back to wall street millennial on this channel, we cover everything related to stocks and investing the gamestop fiasco earlier this year has caused many people to think that the financial markets are rigged by the establishment and hedge funds against individual investors. They hired dozens of accomplished industry professionals and invest hundreds of millions of dollars in proprietary data. The top hedge fund managers have turned themselves into billionaires from the fees that they charge to their investors. Their clients consist of billionaires and large institutions with large sums of money to invest in general.

Individual investors cannot participate in the performance of hedge funds, but the biggest secret the hedge funds want to keep from. You is that you're far better off investing in passive index funds than giving them your money. Over the past decade, hedge funds have consistently underperformed the s p 500. A monkey throwing darts at the financial pages of a newspaper would have outperformed most of the so-called experts.

At hedge funds, the swiss bank credit suisse keeps track of the performance of all hedge funds in their hedge fund index. Since 1994, hedge funds have returned a compound annual return of 6.7 percent compared to the s p. 500 return of 10. This means that a 100 investment into the s p in 1994 would have grown to 1 500, while a 100 investment into hedge funds would have grown to 600, which is less than half.

So if you had chosen the simplest investment strategy possible of just buying the passive index, you would have far outperformed the hedge funds. Many hedge funds use complicated strategies which are supposedly less risky than investing in passive stock market indices. This can explain some of their underperformance, but there's an interesting observation to be made before the global financial crisis of 2008. The hedge funds actually did okay about matching the performance of the s p 500 on a risk-adjusted basis.

Their returns were superior to the market, but during the post-crisis recovery, the hedge funds, massively underperformed. During this period, the hedge fund index has roughly doubled, while the s p 500 has almost 10x. If you had reinvested the dividends. There are three main reasons: the performance of hedge funds has lagged the passive indexes, and this will probably get even worse for them going forward in the past.

Financial information was not widely available to individual investors. If you didn't have a bloomberg terminal, it was almost impossible to get up-to-date information about stocks and companies. Since the hedge funds had superior information, they could consistently profit by trading against retail investors, but over the past decade the internet has democratized finance substantially. Now any investor can do their own research online.

Just by reading companies, sec filings and following the financial media, the so-called dumb money of retail investors isn't as dumb as it used to be. Also, hedge funds have more competition with each other during the 2000s, when hedge funds were outperforming the market and making billions of dollars, everyone on wall street wanted to get a piece of the action. The number of hedge funds rapidly grew, and there are now more hedge funds than there are stocks on the major u.s exchanges. This causes many positions to get crowded and reduces the amount of profits each hedge fund can make.

It can also lead to situations like gamestop when there are too many hedge funds shorting the same stock. The second problem with hedge funds is that many become victims of their own success. After a hedge fund has good performance for a few years. This will attract more investors.

The hedge funds gladly take on the money because they want to increase their assets under management and bust their fees. Let's say: you're a hedge fund managing 10 billion dollars. You do some research and think that macy's is undervalued as just a random example. You want to initiate a position in macy's stock worth five percent of your portfolio or 500 million dollars.

This seems like it should be fine, as the company has a market cap in excess of six billion dollars on an average day, macy's trades between 10 and 15 million shares per day, based on its current share price. This is roughly 300 million dollars worth of trading volume per day. If you want to buy 500 million dollars worth of macy's stock, you alone would count for more than one hundred percent of the daily trading volume. If the stock is twenty one dollars, when you start buying, you'd, probably jack it up to twenty two or twenty three dollars at least purely based on the lack of liquidity, instead of buying 500 million dollars in one day, you'd probably have to buy 50 million per Day for 10 days to build up the position, this significantly decreases your flexibility, trade, around earnings, releases or other important events.

The biggest real world example of this problem is warren buffett, while berkshire hathaway isn't a hedge fund, it buys and sells stocks in a similar manner to a hedge fund. Berkshire manages hundreds of billions of dollars and they massively move the market whenever they enter or exit a position. Large hedge funds can lose one or two percentage points on slippage. Every time they enter or exit a position.

Imagine if you had to pay a 2 fee. Every time you traded on your personal brokerage account, this would make any type of active trading strategy infeasible in the u.s. Almost all retail brokerages charge no commissions on stock trades. Hedge funds use investment banks to execute their trades.

These institutional brokers charge significant fees, but the most important reason for hedge fund underperformance is their excessive fees. They typically use the 2 and 20 fee structure. This means they charge a flat 2 fee of assets under management plus 20 of any gains if they lose money. In a year they will still take the 2 flat fee, while the 2 and 20 structure is common industry practice.

Some hedge funds have fee structures which are even more onerous and complex. If the s p 500 returns 10 in a year, the hedge fund would have to make 15 returns just to match that after fees and what's even more crazy, is that all hedge funds are required to disclose their positions every quarter. They don't have to disclose short positions and there is a delay of a few weeks, but for many hedge funds, it's a viable strategy to copy their trades and not pay any fees. For example, one of the most famous and successful hedge fund managers today is bill.

Ackman his hedge fund pershing square, manages about 13 billion dollars. He buys stocks which he thinks are undervalued and rarely goes short he's a long-term investor. With most of his positions being held for multiple years. His longest standing position is restaurant brands, international, the parent company of burger king tim, hortons and popeyes.

It's done pretty well in this period, increasing 77 percent plus dividends, but pershing square charges, a 1.5 annual management fee plus 20 of gains each year. If you were an investor in pershing square, the flat management fee alone would have cost you about 10 percent and performance fees would have cost you far in excess of 20 because of how they compound each year. So for the 77 gain in the stock price. You'd, probably only get about half of that net of fees.

If you just looked at purchasing square's sec filings and copied the position yourself, you would have gotten pretty much the full 77 percent. Some hedge funds have very short holding periods, so you can't replicate them by the time their sec filings are released, they've, probably already exited most of their positions, but for a long-term investor like bill ackman, it's pretty insane that anybody is paying him such high fees when His holdings are publicly available for free and it's not just bill ackman. There are hundreds of similar hedge funds who have long holding periods and charge very high fees, and the investors of these hedge funds are billionaires or institutional investors. They are supposed to be sophisticated.

They're often investing hundreds of millions of dollars into these hedge funds and paying tens of millions of dollars worth of fees. They could just hire one person to read the hedge fund's sec filings every quarter and make a copycat portfolio. You could even hire this person part time because they only have to work for one day each quarter, so this would only cost them a few hundred dollars a year. But inexplicably many so-called sophisticated investors continue to park billions of dollars into these types of hedge funds and pay hundreds of millions of dollars in fees.

These hedge funds invest tens of millions of dollars in research in hiring investment professionals by reading their publicly disclosed holdings. You are effectively getting all this research for free. You can find all hedge fund filings on the edgar database on the sec website. You can also look at free websites such as whalewisdom.com, which have a simpler user interface.

Most hedge funds fail to beat the market for the few that do beat the market. Most of those gains are eaten up by fees anyway, you're, probably better off, just owning a passive index fund or doing your own research to pick stocks yourself. This way, you at least don't have to pay fees, alright, guys that wraps it up for this video. What do you think about hedge funds? Let us know in the comments section below, as always.

Thank you so much for watching and we'll see in the next one wall, street millennial signing out.