A recent CNBC commentary argued that hedge funds are a risky bet, largely because the sector has trailed the S&P 500 index for five years, as well as the fact that it is hard to identify managers who can perform well. The suggestion by one of the quoted experts and the author’s apparent conclusion is that many investors are better off sticking with passive investments–that is, mutual and exchange-traded funds (ETFs) that invest in a sector or broad universe of securities.

In reality, while the views about hedge funds have some merit, the assertion that passive investments are less risky seems flawed.

The only market that matters?

Before detailing why, certain of the author’s assumptions need to be addressed. First, evaluating hedge fund performance relative to that of equities is like comparing apples and oranges. Would the author make the same argument with respect to fixed-income securities, commodities and real estate? Is the stock market–more specifically, the S&P 500–the only gauge that matters in making such an assessment?

In fact, most institutional investors take account of more than absolute returns alone, including the amount of risk that was assumed in the pursuit of performance. If an investment manager had decided to employ a strategy, say, of shorting S&P 500 index put options every month since the March 2009 market lows, he would likely have performed substantially better than the benchmark. Does that mean this particular approach is less risky than buying a passively-managed ETF?

Aside from that, a focus on how hedge funds have fared in recent years, when return dispersion have been low, correlations have been high, and equity markets have been juiced up by the Federal Reserve’s ostensible goal of boosting share prices in the hope of engendering the wealth effect, seems narrow-minded, to say the least, reflecting what some might characterize as recency bias.

Not so logical

Such a view also gives short shrift to the fact that markets tend to revert to the mean. Admittedly, getting the timing right is often a major challenge, and it is not always clear that values are out of whack–on the upside or the downside–until well after the fact. Still, is it right to suggest that the hedge fund sector’s recent poor performance should be extrapolated forward? If so, then why not take things to their logical extreme: shouldn’t investors simply buy the best-performing stock of the past five years–Natural Health Trends Corp (NHTC), which is up more than 23,000%?

Regardless, the argument that passive investments are less risky than hedged investments seems dubious for other reasons. For one thing, whether a mutual fund or ETF is actively or passively managed, it’s a good bet that it will decline in value if equities more broadly fall into a bear market. If history is any guide, the length of the current bull run, together with the market’s lofty valuation and the fact that fundamental conditions are less than robust, suggest that being long right now is a risky proposition.

Even if one assumes that the long-term trend for stock prices is up and that investors need not worry about short-term fluctuations, there are other reasons to be concerned about the risks associated with passive investments, which now represent a healthy share of overall totals. Citing data from Bank of America, Bloomberg reports that “passive investments have gone from one-fifth of long-only assets under management to one-third today.”

Cumulative flows into passive vs. active funds

Illusion versus reality

For a start, it is taken for granted that such investments are easy to get in and out of, unlike with hedge funds. But circumstances have changed, and some developments suggest the promise of instant liquidity is more illusion than reality. Generally speaking, mutual fund and ETF investors assume that when they want to exit a position, “the market,” a fund sponsor or some other entity will be there to take the other side.

While that has been largely true until now with respect to most fund products, some recent events, including the December blowup of Third Avenue’s junk bond fund, which had a sizable percentage of hard-to-trade assets in its underlying portfolio, may represent the proverbial canary in the (illiquidity) coal mine. Things came to a head, Reuters reported, when “the $789 million Focused Credit Fund abruptly blocked investor withdrawals and announced on Dec. 9 it would liquidate the fund’s assets.”

Naturally, some would argue that the investments held by that fund are not representative of publicly-traded markets overall. However, changes in their underlying structure suggest that even those investments that are thought to be readily tradable might be hard to shift under certain conditions, especially when others are attempting to do the same. As detailed in “Market Liquidity: A Deteriorating Outlook,” an evolving regulatory framework, the rise of high frequency trading, proliferating exchanges, and years of aggressive central bank intervention have undermined liquidity, more broadly speaking.

Elephants through the revolving door

In any sort of disruptive trading environment, including a garden variety bear market, the illusion of liquidity could cause problems in and of itself. Confident that they can reduce risk by picking up the telephone or logging into an online account and initiating a trade, investors may feel they don’t need to restructure portfolios until it is absolutely necessary, raising the risk of an eventual mass exodus that resembles elephants stampeding through a revolving door. Alternatively, some may decide that the best way to batten down the hatches is to liquidate the investments they believe are easy to sell–which could prove difficult if others are doing the same.

Under the circumstances, some might argue that with market liquidity being called into question, and with many hedge funds being able, in theory at least, to capitalize on falling prices–a feature not available with most passive approaches–actively-managed alternative investments may be the less risky option right now. (For more on the subject, please see “Hedge Fund Investing: A Contrarian Dream.”)

Michael Panzner

Michael J. Panzner is a 30-year Wall Street veteran and the author of three books, including Financial Armageddon, which predicted the 2008 global financial crisis.