No Wonder They Call Hedge Funds 'Smart Money'!

One of the most amusing phrases on Wall Street is "smart money."

This phrase is used to describe the handful of professional investors whose abilities and foresight are thought to be so acute that they spot the big money-making opportunities before the average Joe Pro.

The smartest of the "smart money" is thought to be hedge funds.

A look at recent performance suggests that hedge funds are indeed extremely smart money, though not in the way that most people think.

As the chart below shows, on average, hedge funds are no smarter about picking stocks or other investments than anyone else. In fact, they're decidedly, startlingly worse.

The blue line in the chart below is the relative performance of the average hedge fund since 2010. The purple line is the relative performance of the S&P 500. The chart is from Ben Inker of GMO:

But hedge funds are absolutely brilliant money-making schemes for those who run and work for them.

The fees on a well-run S&P 500 index fund are about 20 basis points a year.

That means that, every year, for every $1 billion a fund has under management, the fund manager makes $2 million.

The annual fees on a dime-a-dozen hedge fund, meanwhile, are "2 and 20" - 2% of assets and 20% of any gains, regardless of whether the gains are the result of the fund manager's activities or simply a rising market.

That means that, for every $1 billion under management, the hedge fund rakes in $20 million per year. And if the market should rise, say, 20% in a year, the fund will collect another $40 million.

Put differently, in a year in which the market goes up 20%, the manager of a $1 billion S&P 500 index fund will make $2 million. The manager of a hedge fund that performs in line with the market, meanwhile (which most haven't in recent years), will make $60 million.

Smart money, indeed!