Hedge funds, the most sophisticated investing vehicles in the financial world have had another mediocre year. The HFRX, a widely used measure of industry returns, is up by just 3% in 2012, compared with an 18% rise in the S&P 500 share index. Although it might be possible to shrug off one year’s under-performance, it seems that their problems extend way beyond 2012.
According to The Economist, The S&P 500 has now outperformed its hedge-fund rival for ten straight years, with the exception of 2008. A simple-minded investment portfolio—60% of it in shares and the rest in sovereign bonds—has delivered returns of more than 90% over the past decade, compared with a meager 17% after fees for hedge funds. And for that "fabulous" returns, clients pay through the nose, with a fee structure of 2% of annual assets and 20% profit sharing. Basically, investors are paying very expensive fees for very mediocre results
What has been is long gone
This has not been the case in the past. Years ago, hedge funds actually made a lot of money for their clients. But there are two main reasons why this has changed.
1). Crowded market: Over the past 10 years, everyone decided they wanted to launch a new hedge fund. In practice, many of these funds employ the same strategies. Today, hedge-fund assets are at a record $2.2 trillion and most of this money ends up chasing the same opportunities. This, in turn, means fewer opportunities and mediocre results.
2). A low yield world: In a world of expanding credit and falling cost of capital (the bond bull market between 1980 and 2010), returns came easy. Hedge-fund managers could produce acceptable returns by borrowing money at low interest rates and investing that cash into high-yielding fixed-income assets. Nowadays, high- yielding income assets are scarce to non-existent. This is a massive hit to hedge fund managers and their results.
The much safer alternative
I believe that by investing in a distressed sector, you are more than likely to easily outperform any hedge fund. The most distressed sector today is the technology sector. This sector hasn't benefited from the latest rally in equities and was left behind. Following the Dot.Com bubble back in 2000, many individuals are squeamish about getting back in the sector. Companies that traded at P/E multiples of 50x and up back in 2000, are barely scratching the double digit territory. Here are my three favorite companies that will outperform in 2013:
1). Microsoft Corporation (NASDAQ:MSFT): The virtual monopoly in the operating system world trades at a forward P/E of only 8.7x and price/book of 3.18. You might think that this cheap valuation tag is a result of the company's stagnant growth, but this is not the case - Mr. Softy trades at a PEG of 1.14. The company is producing earnings at a mouthwatering gross profit margin of 35% and has a dividend yield of 3.6%. It's practically a super profit machine trading at a price of an old sewing machine.