Why the Smart Money was So Dumb in 2011

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If your 401(k) was down in 2011, don’t hang your head. You have plenty of company. Many of Wall Street‘s most successful investors were losers in 2011 as well.

According to Hedgefund Intelligence Database, 60% of all hedge funds lost money in 2011. That wasn’t much worse than annus horribulus 2008, when 70% of hedge funds lost money. Of course, in 2008 they lost a lot more money than last year. But, still, on average they were down less than the stock market overall that year.

In 2011, hedge fund managers couldn’t even claim that achievement. As a group, hedge funds dropped 5%. The ones that focus just on stocks were down a full 19%. That was worse than the overall stock market as measured by the Standard & Poor’s 500, which was basically flat for the year. And it wasn’t just hedge funds. Over 70% of all mutual funds also underperformed their respective markets (bonds or stocks or whatever) in 2011.

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Among the losers were some of the investing world’s stars. Take John Paulson, the hedge fund manager who so shrewdly called the housing bust and figured out, in sometimes ethically questionable ways, how to profit from it. In 2011, he bet big on banks and gold, and neither paid off. His firm’s flagship fund reportedly lost more than 50% of its value in 2011. Famed mutual fund managers Bruce Berkowitz and Legg Mason’s Bill Miller also had disappointing years. But it wasn’t just stock market investors who got tripped up. Even bond investors like Bill Gross, who runs the world’s largest mutual fund, had a hard time calling the market in 2011.

So what gives? Each investors story of folly is slightly different. But here are four reasons 2011 made the investors we normally think of as smart look pretty dumb.

First, many of the investors were much more enamored of financial stocks than they should have been. That was true of John Paulson, but it was also true of Berkowitz and Miller, all of whom were betting that banks would rebound in 2011. But lingering problems with bad mortgage loans and ties to European debt problems caused banks to suffer. Shares of Bank of America, for instance, were down over 50%. Even the stock of powerhouse Goldman Sachs slid more than 40%. In fact, all you had to do in 2011 was stay away from the financial sector and you were able to beat the market. Excluding financial shares, the S&P 500 was up 3.6%, or nearly 9% better than the average hedge fund.

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Second, volatility. While the stock market was flat for the year, it was far from a smooth ride. The market rose in the first few months of year, dropping briefly after the Japanese tsunami and nuclear disaster. It then plunged starting in May and throughout the summer, dropping for five straight months, before leaping ahead 10% in October — one of the best monthly gains in years. But that rally petered out in November and December — two flat months for the market — leaving stocks flat for the year. Most professional investors missed those moves. Charles Gradante, who is co-founder of a hedge fund advisory firm Hennesse Group, says by October many funds had pulled a significant amount of money out of the market. That meant they missed the rally and ended the year down.

Third, the smart money probably isn’t a great definition of hedge fund managers anymore. The ranks of people who managed these funds only open to high-net worth investors used to be an exclusive bunch. These days there are around 10,000 hedge funds. As for mutual funds, the number is more than double that. That means there are going to be more duds in the bunch. It also means there are going to be more home runs that we take notice of, and ascribe some significance to. And to be fair, 2011 wasn’t without those too. A 35-year-old manager led hedge fund Tiger Global to a 45% return last year. But don’t be surprised when his 2012 returns aren’t as good.

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The last reasons the smart money looked dumb is in part a result of their own creation. Hedge funds and mutual fund managers, like the rest of the 1%, live in an increasingly different economy and world than the rest of us. From their seats, coming into 2011, the world looked pretty good. The stock market was up in 2009 and 2010. Corporate profits were up. And bonuses were back on Wall Street. But to the rest of us, the economy was still muddling along with a near 10% unemployment rate. Stock and bond fund managers seemed to miss that, coming into the year a lot more bullish than they should have.

In the end, 2011 showed again that perhaps the smartest investors in the market are those who put their money in index funds that blindly track the market and leave it there. Yes, if you had done that you wouldn’t have made any money in 2011, but you won’t have lost nearly as much as the so-called smart money did, either.