Couch-potato index funds vs. jet-setter hedge funds: No contest

Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.

Five-star resorts on tropical islands, exclusive golf club memberships and blazing red Ferraris are Gold Class member playthings.

It's tough not to envy jet setters, especially when stocks teeter. That's because the world's super rich can invest in hedge funds. Clever managers with crystal balls can short the market before it tumbles.

Hedge fund doors, however, get slammed in most people's faces. To gain entry, investors need massive salaries or at least $1-million in investable assets.

Backdoor entries do exist. But don't bother. A simple portfolio of index funds may be far more effective.

Hedge funds usually charge a 2-per-cent annual management fee. Managers also take 20 per cent of any profits made by the fund. So if the fund earned 10 per cent before fees, managers would take 2 per cent of the assets. That leaves just 8 per cent.

But the fees aren't finished yet. Managers also take 20 per cent of the 8 per cent that's left. So if the fund earned a 10-per-cent gain before fees, the investor would make just 6.4 per cent.

American Scott Burns introduced something simpler and cheaper back in 1991. He called it the Couch Potato portfolio. Investors split their money into two simple funds. Half goes into a U.S. stock index. The other half goes into a bond index. It's like buying at Costco versus a hedge-fund-like boutique. Costs are less than 0.2 per cent a year.

Hedge Fund Research Inc. posts an extensive compilation of global hedge fund returns. What's surprising is that those country club products run on fumes and desperate prayers.

Between January, 2003, and September, 2015, the typical hedge fund averaged a compounding return of 0.94 per cent a year after fees. By comparison, the U.S. Couch Potato portfolio averaged 6.3 per cent.

Hedge funds are supposed to protect investors when markets fall. But in 2008, when global markets collapsed, the average hedge fund dropped 23.3 per cent. The simple Couch Potato portfolio fell less, dropping just 20.4 per cent.

Fifteen years ago, The Globe and Mail's Ian McGugan introduced a Couch Potato portfolio for Canadians. More diversified than the American version, it called for a three-way split between a Canadian bond index (XBB), a Canadian stock index (XIC) and a U.S. stock index (XSP).

To add further diversification, he followed up with a Global Couch Potato portfolio. It gets split four ways. It comprises a Canadian bond index (XBB), a Canadian stock index (XIC), a U.S. stock index (XSP) and an international stock index (XIN). In each case, investors rebalance their portfolio annually, bringing it back to its original allocation.

Data provided by Bank of Nova Scotia's Canadian Hedge Fund Index shows that the average Canadian hedge fund beat its global counterpart.

But Canada's Couch Potatoes triumphed. The typical Canadian hedge fund has averaged 4.38 per cent since 2005. By comparison, the Classic Couch Potato portfolio averaged 6.7 per cent. The Global Couch Potato averaged 5.46 per cent.

Nor did Canada's hedge funds protect investors during market drops.

Since 2005, they recorded three calendar year losses: 2008, 2011 and 2012. The Classic Couch Potato dropped once, in 2008. The Global Couch Potato Portfolio fell twice, in 2008 and in 2011. In fact, when the markets did drop, hedge funds slipped further than the Couch Potato set.

Hedge fund returns, however, could be worse than we think. They aren't usually registered with security commissions. As a result, fund managers can report results when they're strong. They can abstain from reporting when results are weak.

Nicolas Bollen and Veronika Pool outlined this abuse in their American Finance Association publication, Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution.

Such abuse looks worse when accounting for hedge fund extinction. Princeton University's Burton Malkiel and Yale School of Management's Robert Ibbotson studied hedge funds from 1996 to 2004. They found that 75 per cent of them went out of business. The disappearing funds weren't available for data compilation.

As a result, Prof. Malkiel and Prof. Ibbotson calculated that the average returns reported in databases were overstated by 7.3 per cent annually during their eight-year study.

So if you aren't part of the jet set and you can't afford hedge funds, you can still afford to chuckle. Portfolios of index funds are a lot less sexy. But they do perform better.