The Couch Potato is probably the world’s simplest portfolio. Yet it’s running circles around what may be the most sophisticated and exclusive collection of investments on the planet: the Global HFRX Hedge Fund index.

Rebalanced once a year, the Couch Potato comprises half of its assets in the Vanguard Total Stock Market Index with the other half in the Vanguard Inflation-Protected Securities index.  It’s a simple combination of stocks and bonds, with expenses running just 0.19 percent a year.

Hedge funds, in contrast, cost roughly 2 percent per year, with the managers absconding an additional 20 percent of the profits.  Fund leaders reap salaries that would satisfy a sultan, while the average hedge fund investor earns mediocre returns or worse.

From January- August 2012 the Couch Potato portfolio gained +8.1 percent, compared to just 1.8 percent for the HFRX index reserved for accredited, high net worth investors.

The world’s simplest portfolio also beat the average hedge fund in 2011, 2010, 2009, 2008, 2007, 2006, 2005, 2004, and 2003. Including the year to date 2012 returns, the Couch Potato has thrashed the HFRX Global Hedge Fund Index for ten years in a row:

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 to 8/9/12
Couch Potato Portfolio +16.2% +10.5% +3.6% +9.9% +8.8% (20.4%) +19.9% +10.6% +6.7% +8.1%
HFRX Global Hedge Fund Index +13.4% +2.7% +2.7% +9.3% +4.2% (23.3%) +13.4% +5.2% (8.8%) +1.8%

Despite how far the reported hedge funds have lagged the Couch Potato over the past decade, most hedge fund investors would be thrilled with these poor results—because the majority of hedge funds did worse than the hedge fund index average.

Hedge funds aren’t registered with the Securities and Exchange Commission, and fund managers can communicate their results to the reporting services whenever they feel like it. They can also discontinue reporting whenever they want. When the results are strong, managers publish their results with hedge fund index compilers to generate more client investment money.  The added assets under management balloon managers’ income.  But when results are weak, managers often abstain from publishing poor returns. Nicolas P.B. Bollen and Veronika K. Pool outlined this abuse in their American Finance Association publication, “Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution”

The upward bias on reported returns looks even worse when we recognize how many hedge funds go out of business.  When Princeton University’s Burton Malkiel and Yale School of Management’s Robert Ibbotson studied Hedge Funds from 1996 to 2004, they discovered a 75 percent mortality rate. Only the funds that don’t go out of business--and voluntarily report their results--are available for data compilation. As a result, Malkiel and Ibbotson calculated that the average returns reported in data bases were overstated by 7.3 percent annually during the eight year study.

Industry insider Simon Lack recently published The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True (Wiley 2012). Formerly with JPMorgan, where he was responsible for allocating more than $1 billion to hedge fund managers, he suggests that, “If all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good.” According to Lack, investing in hedge funds didn’t become popular until the turn of the millennium.  The average surviving fund generated 7.3 percent (from 1998-2010) but the average dollar invested made only 2.1 percent.   Most hedge fund investors piled into these products after 2002—just in time for their returns to crumble.  Humble Couch Potato investors have (concealed) the last laugh.

If you had professional help picking hedge funds, hoping their selections would eat the Couch Potato for lunch, you’d probably be disappointed.  In 2008, New York asset management firm Protégé partners bet Warren Buffett that five hand picked hedge funds would beat the S&P 500 index over the following ten years.  Buffett took the bet, and as of January 2012, the race was nearly even.

Market volatility is supposed to benefit hedge funds, but during this tumultuous four-year period, the Couch Potato gave these selected funds a thorough beating.  From January 2008-2012, Protégé’s pet funds fell 5.89 percent. Meanwhile the Couch Potato has gained more than 20 percent on the hedge funds. So it appears that hedge fund investors can have their return in mystique. Too bad about the money part.

Will the Couch Potato portfolio continue to hammer the aggregate return of hedge funds?  I think it will.  Cheap portfolios, after all, have higher statistical odds of success. 

$10,000 invested in Couch Potato Portfolio vs, HFRX Hedge Fund Index 2003-2012

Hedge Fund Graph