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Chimps vs. Hedge Funds in the Race for Returns


Passive investing often wins, but it all comes down to timing.

After a 19% decline in 2008 for hedge funds -- the industry's worst year ever -- Hedge Fund Research's HFRI Funded Weighted Composite closed out 2009 with a gain of 20%.

Had you bought an S&P 500 (SPX) index fund at the same time last year, you would have posted a gain of 24.7%.

The stomach-churning results for investors in the pricey 2-and-20 hedge fund sector are reviving the age-old debate over whether actively managed investments really produce higher returns than passive investments.

"Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement," William Sharpe, finance professor at Stanford's business school and winner of the 1990 Nobel Prize in Economic Sciences, wrote in 1991.

In an article on the topic, Daily Finance also points to a 2008 study by Kenneth French, a finance professor at Dartmouth's Tuck School of Business, which quantified the cost of active management: "On average, active investors spend 0.67% of the total market cap each year on what, in aggregate, is a futile search for superior returns."

Then, of course, there's this:

A Russian circus chimpanzee named Lusha outperformed 94% of the country's investment funds last year, growing her one million ruble portfolio by 300%.

"It shows that financial knowledge does not play a great role in giving forecasts to how the market will change," said Pavel Trunin, head of the monetary policy department at the Institute for the Economy in Transition in Moscow, according to the Daily Mail.

Can it really be that simplistic? Is it possible to make such a black-and-white case for or against active management versus passive?

The question really comes down to investors' timing, not overall returns. Consider the top performing mutual fund over the past decade as an example, says money manager Ryan Krueger of Houston's Krueger & Catalano. Ken Heebner's CGM Focus Fund (CGMFX) posted 18% average annual gains over the past 10 years. Its top holdings currently include Goldman Sachs (GS), Ford (F), Baidu (BIDU), Freeport McMoRan Copper & Gold (FCX), and FedEx (FDX).

Sounds pretty good, right? Yet the average shareholder lost 11% annually, Krueger says.

"Investors got in and out at the wrong times -- that's what a good adviser can do for you. It's not necessarily a matter of what to buy, it's also largely a matter of when."

So, when you're sitting across the desk of a prospective adviser, how do you ensure your best interests are priority Number One?

"There's one way that trumps any and all others -- look them in the eye and ask, 'Exactly where do you have all of your own money?' " Krueger says. "It doesn't guarantee success, but it sure as hell confirms where they'll be spending the majority of their time."
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