If you don’t freak out soon, Paul Tudor Jones won’t make his 27%

Getty Images

Hedge funds have had a disappointing run lately. Wall Street hasn’t been short on explanations.

Last year, the most common excuse was the hot stock market, which was up 30%. Hedge funds are hedged, and don’t do that well when the market is going straight up, so the story went.

That’s not something the hedgies can say this year. The stock market is up a more normal 5% in 2014, yet most hedge funds are still trailing the S&P 500 index. The Wall Street Journal on Friday highlighted a number of large funds that are having a particularly bad year, most notably legendary hedge fund trader Paul Tudor Jones, whose main fund is down 5% this year.

What explanation has Jones come up with? The market, he says, is too calm.

In early May at the Sohn Investing Conference in New York, Jones complained that, without wide swings in the stock and bond markets, his fund won’t go up. Without volatility, he can’t make money investing, he said. This seems like an odd admission.

My notion of a hedge fund is that it is a series of sophisticated, targeted bets on stocks or bonds or some portion of the market. For that, investors pay a 2% annual fee and 20% of their profits to the fund manager. Jones charges a 27% performance fee, on top of a 2.75% annual fee.

But if you listen to Jones, that’s not what you get when you invest in a hedge fund at all. What you are really getting, if Jones is right, is a one-way bet on volatility. If volatility goes up, you will make money. If it goes down, you lose, at least relative to the rest of the market. Jones’ ability to predict interest rates or Japan’s economic prospects doesn’t actually matter all that much.

And it turns out, Jones, a three-decade veteran of the hedge fund business, is right. Hedge funds tend to do well in years in which volatility is rising. And they suck wind in years when it is not. For instance, since 2000, hedge funds on average have beaten the market by 11% in years when volatility is going up. The funds have trailed the market by a little over 3% in years in which volatility has been flat or down.

Then again, we’re just focusing on one stat. Other market metrics, like interest rates, may better predict the performance of hedge funds. And 15 years isn’t that long. What’s more, Jones manages a so-called macro hedge fund, which makes bets based on big picture investment themes. Other kinds of hedge funds, like distressed debt funds as an example, may not be as dependent on volatility rates.

But Jones’ hedge fund theory does nicely explain another phenomenon. For the past few years, a number of prominent hedge fund managers, Jones included, have warned that the Federal Reserve’s efforts to push down interest rates and stimulate the economy will eventually end in disaster–a calamity that will prove more damaging than the financial crisis.

Some have accused hedge funds of talking their book. But this explanation doesn’t make a lot of sense. Lower interest rates push up stock and bond prices and generally should be good for hedge funds. They should like what the Fed is doing.

But if you are a hedge fund manager, and you know that you only make money when the market is volatile, the best way to boost your performance is to try your best to produce panic. And if people are already skeptical of the Fed, then that seems like an easy target. (You might also bash Obama and healthcare.)

That may explain why prominent hedge fund manager Paul Singer last May wrote that the Fed’s bond buying program would “ultimately destroy the value of money and savings while uprooting the basic stability of their societies.” Scared yet? Jones himself has called the Fed’s policies misguided.

The bigger problem for hedge funds is this: There are now much cheaper ways to bet on volatility. Over the past few years, a number of fund companies have launched low-cost ETFs that track volatility. The ProShares Short-term Volatility ETF (VIXY), for instance, charges a single annual fee of 0.85%. I’m not saying you should buy those. Like hedge funds, volatility ETFs have been lousy investments, and they are poorly constructed. You lose more money than you should when volatility is falling, and you make less when it is rising.

But if you are looking to lose money, and considering investing in a hedge fund, the VIX funds are a much cheaper way to do it.

Subscribe to Well Adjusted, our newsletter full of simple strategies to work smarter and live better, from the Fortune Well team. Sign up today.

Read More

CryptocurrencyInvestingBanksReal Estate