One possibly permanent feature of financial media is that every so often, there will be a piece about how lucrative it is to run a hedge fund even if that fund's long-term return is lower than that of the S&P. And then there's the inevitable pushback that the funds in question tend to deliver S&P-like returns with a lot less risk. And the pushback to that is, basically: If I nearly quadrupled my money by holding the S&P over the last decade, how much do I really care that there were a couple unpleasant weeks in early 2025, most of 2022, early 2020, late 2018, etc.? It's all water under the bridge.

One irony in all of this is that both sides are right, from their perspective: households saving for retirement are the ideal holders of an asset class like equities that has a similar risk/reward tradeoff to other assets, but tends to have more of both risk and reward. Being temporarily poorer-on-paper at various points in your 20s, 30s, and 40s is a perfectly reasonable price to pay for having enough money to retire on in your 60s. The people looking at long-term equity returns are, ideally, people who will be mostly buying equities for a decade or more, and will then sell them down over time as they shift towards fixed income, before reaching the point where they gradually liquidate their assets in retirement. Whereas the typical hedge fund investor (LP) is an institution like an endowment fund or pension, which expects to continuously take money out.

Suppose a college has a $1bn endowment fund, and that fund needs to distribute $50m/year. Sick of paying excessive fees, they just park it all in SPY. If they happened to make that choice at the beginning of 2022, they lost about $180m, and spent $50m, and now they're down to $770m. This means two things: first, that their fund now needs to distribute 6.5% of its assets each year, rather than 5%. And second, when they're distributing that money, they're selling cheaper stocks.¹ Our hypothetical endowment fund might have diversified into fixed income, too, and that usually saves equity-heavy portfolios—but not in 2022!

Instead, they might go back to the drawing board and ask: what are the asset classes they have a comparative advantage owning? Those might include:

1. Anything that trades a lower expected return for either lower variance or, ideally, an inverse correlation with other assets.

2. Investment strategies that are tricky to underwrite—not because these allocators necessarily have special skill, but because the longer they plan to be involved in a fund, the more upfront research they can justify since they amortize its cost over many years.

3. Any vehicle whose duration is longer than other investors would tolerate. The nice thing about knowing your liquidity needs many years in the future is that you know the liquidity you won't need.

4. Any investment vehicle that's run in a pass-through entity and that realizes most of its returns as short-term capital gains.

This set of constraints naturally leads them to invest in private equity, venture, real estate, and other slow-moving assets. But it also means that they're natural investors in hedge funds; their tax treatment produces a liquidity barbell where they're also going to realize a higher return than a taxable investor would from backing an investment vehicle that does short-term trades.

So what their overall portfolio looks like is that they'll have a slug of traditional assets, some structurally illiquid but hopefully higher-return private alternatives, and, as ballast, some hedge funds that produce returns that aren't very correlated with the broader market (to be clear, this isn’t all hedge funds, but a very specific flavor of them–factor neutral, market neutral, etc.) Though allocators will also look at other strategies that do take direction risk, but try to do so in an uncorrelated way, like specialized credit or volatility funds, tail hedging funds, or some flavors of macro). The relative weightings of these vehicles will depend partly on returns, and partly on when liquidity shows up—right now, for example, many endowments are overweight VC and PE compared to where they'd like to be, because the effective life of those vehicles has gotten longer. When (if?) they do get capital out, they'll probably rebalance into other asset classes. And when equities are weak, they'll redeem a bit of the uncorrelated part of their portfolio and put it back into the market to keep their average expected return high.

But that's not the only reason they care about volatility. Another way to look at it is that volatility is a measure of how much the market thinks the news flow over some period of time—a day, a month, a quarter—affects the underlying value of the company. It's a guess, and one that people generally make indirectly by trading the stock.²

But, if volatility of asset prices systematically overstates the risk of owning those assets, that implies that betting on mean-reversion generally works! In one sense, that's obviously true: there are investors who demonstrate persistent skill at buying low and selling high. But they aren't just going long everything that hits a 52-week low and vice-versa; on average, stocks that go down keep going down, and stocks that go up keep going up, too. When they reverse, it's because either they've gotten unmoored from fundamentals or because those fundamentals have changed. For example, if a company has a steady buyback, then its growth rate in earnings per share mechanically rises whenever the stock drops faster than cash flow. It's not quite as automatic that every company whose stock rips for no reason, or because management engineered a pop, will do a secondary offering, but some of them seem to have gotten it down to a science.

The real answer to the volatility puzzle is that different investors have different exposures to volatility, and the relative volatility and risk-adjusted returns of different asset classes are just the intersection of very abstract supply and demand curves. When more equity investors are passively saving their money and investing set amounts, equity volatility gets lower over long periods (see: “short the VIX” craze circa 2017)—new flows into 401(k)s purchase a larger proportion of shares outstanding when the market is down—but gets higher in the short term, because there are fewer investors who will shift assets out of fixed income and cash and into equities when the market slides. For investors who use leverage, or who face redemptions, volatility matters because it means forced selling when prices are low (and if those investors are also keeping constant leverage, it means forced buying when prices are high).

If the portfolio you're looking at is 100% net long conventional asset classes, and if you think it's absurd to pay high fees in order to match the S&P with less liquidity—lucky you! You're part of society's financial shock absorber, a middle class or above saver in a rich country with functioning capital markets. But if you're in that position, there's a very real sense in which joking about how the S&P has outperformed complicated multi-manager setups year-to-date is a form of financial punching-down. They have a different benchmark, and a harder job. And they're doing you the very generous service of ensuring that the next time you buy the S&P 500, the price of every single component reflects the collective attempt by thousands of professionals with massive data and analytics budgets who are all trying to push the price 1% closer to optimal.

Volatility, risk of ruin, and the consumer versus institutional balance sheet all play a role in the Diff model of the world. For example:

• The more efficient the market, the harder it is to define your terms when you talk about efficiency.

• The mechanics of volatility spiking during panics ($).

• Managing the collective balance sheet means financializing more assets ($).

• How hedge funds synthesized an asset class from a compensation scheme ($).

Join the discussion!

1  One of the hardest ways to make money is by paying the ongoing opportunity cost of having lots of liquidity to deploy in situations like this. People who buy at the bottom usually aren't that excited, and are often thinking that the next likely move is another leg down but that prices are low enough that they feel safe owning something that cheap. This tends to be true on average because the people who think they're buying at the bottom are going to be more aggressive, which means they'll trade first.

2  Options are in part a direct measure of volatility, but the implied volatility of options doesn't necessarily match the realized volatility of the stock. Sometimes, this is because of investor behavior—the prevalence of those who sell volatility to harvest a little excess return while gambling on stable markets relative to those who like buying short-term options because of the built-in leverage. And options also express implied probabilities of binary events. A biotech stock coming into an important clinical trial will usually be volatile, but the implied volatility of options on it can be higher still if the outcome of that trial is that it either loses most of its value or triples.