Mutual Funds Versus Hedge Funds

Mutual Funds Versus Hedge FundsNote: This post was written by the previous owner of this blog in 2012.

Warren Buffet made a bet, for charity, with a prominent hedge fund that they would not beat the S&P Index over the course of 10 years.  Four (4) years into the bet, Warren Buffet is proving that his theory is correct.

The wager that began on Jan. 1, 2008, pits the Omaha, Nebraska, billionaire against Protégé Partners LLC, a New York fund of hedge funds co-founded by Ted Seides and Jeffrey Tarrant. Protégé built an index of five funds that invest in hedge funds to compete against a Vanguard mutual fund that tracks the Standard & Poor’s 500 Index. The winner’s charity of choice gets $1 million when the bet ends on Dec. 31, 2017.

The Vanguard fund’s low-cost Admiral shares returned 2.2 percent, with dividends reinvested, from the start of the bet through Feb. 29, as stocks rebounded from a 12-year low in March 2009. The hedge funds fell about 4.5 percent, based on Protégé’s index returns for the first three years and results since then for the Dow Jones Credit Suisse Hedge Fund Index, which has roughly tracked the group of unidentified funds when adjustments are made for extra fees.

The article goes onto say that hedge funds have underperformed because of fees.  “In addition to the 2 percent management fee and 20 percent performance fee that hedge funds typically charge, the funds of funds add another layer of fees, on average 1.25 percent of assets and 7.5 percent of any gains.”  That’s a lot of money skimmed off the top before it gets to the investor.

It seems that the winners in hedge funds are the managers who collect the fees and not the investors who invest the resources.  So for those of you out there who think that 1 percenters may have better investment options than the 99 percent, Warren Buffett is proving you wrong so far.

 

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13 Comments

  1. so

    Why not find some good local venture funds or do some angel financing? At least then you have an opportunity to get to know the portfolio company / companies…

    Reply
    1. iam1percent

      The reason I give my money to a mutual fund manager or plan to give it to a hedge fund manager is because they have the time to research and understand a company’s business. Quite honestly, I don’t have the time to get to know the intricate details of a company to do angel financing. This is why I don’t invest in individual stocks…I leave that up to professionals to do it full time. Am I missing out on potential returns? Sure, but my goal now is bringing in the income and leaving the growth of my investments to professionals.

      Reply
  2. tom

    Your last line makes it sound like you are still on the fence.

    What is keeping you interested in hedge funds? You are only using your own money to get someone else rich. They get 2% of everything regardless and 20% of any profit. I want my money to work for me and me alone.

    You would be much better off going with a fee-based financial manager. My father’s company charges 0.25% per year to manage your portfolio and uses ETFs, index and low cost mutual funds to keep other fees to an absolute minimum. I’m not going to mention the company name since I am not trying to sell you on the company, but companies like his are far superior to hedge funds which are only out to make astronomical amounts of money off their 2/20+ fee.

    Reply
    1. iam1percent

      I’m still interested in hedge funds because it is still not proven that mutual funds do better. Hedge funds have access to financial instruments that are not available to everyone. The 20% fee is only applied after they hit a return goal. For example, they may say that any profit over and above an 8% return will be assessed a 20% fee, there is no fee on the first 8% of earnings.

      The bottom line is that its still too early to tell from Buffett’s experiment which is still why I’m on the fence.

      Reply
      1. tom

        Correct on the 20%, but you are still assessed a 2% fee overall + the 1.25% fund of fund fee + something else + something else on all of your money regardless of performance. That’s 13+x higher than a typical low-fee asset manager, who will probably get you better net returns anyway. If you go to a big enough low-fee investor, they probably have enough under management to have access to the same opportunities as a hedge fund w/o all of the absurd costs.

        As you can probably surmise, I distrust hedge funds. The biggest managers creating the highest returns also have the highest minimums. The 1% cannot afford those minimums, so we are left with lesser known funds who are much smaller and have less access to the rare opportunities you seek.

        At some point, you’ll have to ask yourself, “how much of my money am I willing to spend THEN risk to gain access to one or two of rare opportunities only afforded to a select few institutional investors?”.

        Reply
  3. Nick

    I totally agree w/ WB. I’d take a simple index fund portfolio over a high-fee hedge fund structure that, in addition to being secretive about what your investments are (I’ve seen many quarterly letters to hedge fund investors…) and charging a high fee, restrict your access to your own money to often one or two weeks per year. This is all in the name of “our managers need the AUM to be stable in order to put their process to work.” (not surprisingly, they’ll take money any time – it’s just getting the money out that’s a problem…)

    In my humble opinion hedge funds (in general) aren’t worth all of the added fees, secrecy and restrictions, especially because you’re not always getting a significantly better return.

    Reply
    1. iam1percent

      I am still going to wait and see. Investors in hedge funds are typically finincially literate to a certain degree, so if high net worth individuals are putting their money in hedge funds, then there has to be a reason for it. If there is a trend that high net worth individuals are putting more money in index funds, then it will tell us something….haven’t seen it yet though.

      Reply
      1. so

        “Investors in hedge funds are typically finincially literate to a certain degree, so if high net worth individuals are putting their money in hedge funds, then there has to be a reason for it.”

        Doesn’t mean it’s a good reason, or that financial literacy (which is hardly a high bar) is equivalent to good judgment. High net worth =/ savvy — in fact, I suspect most high net worth individuals are “muppets” to the fund managers, based on my experience representing both sides…

        My opinion is that inferring good reasons and judgment from the investment choices of high net worth individuals is a dangerous road. There were a ton of high net worth individuals who rode along with the Bill Grosses and Meredith Whitney in their respective hedge funds and got crushed. It seems as though this is attractive to you because high net worth individuals invest there.

        In your AA, hedge funds should occupy the same tier as precious metals, commodities, etc. Liquid Independence is on point.

        Reply
  4. Liquid Independence

    Hedge funds are like mutual funds for the wealthy ಠ_ಠ. Higher potential, higher risk, and higher fees. Mr. Buffett is right. But the only reason I like HFs is that they have access to certain opportunities like getting in on the Facebook IPO during the under writing stages before the public has a chance to buy shares. Once I’m rich enough I plan to allocate a small portion of my alternative investment portfolio to hedge funds that actually “hedge” properly. They aren’t for everyone, but I think hedge funds have a place in the financial industry (=^_^=)

    Reply
    1. iam1percent

      I think this is a good approach. Saavy investors who have the capital continue to invest with HFs because of the returns (otherwise, they’d pull their money out or not continue to invest). I think a portion of assets in a HF is reasonable, as you stated.

      Reply
  5. ShortRoadTo

    Hedge funds are a necessity in the financial world. Any entity that keeps money flowing is necessary for the financial system to remain healthy. Many hedge funds do poorly. The only stories we hear are about the ones with gargantuan returns. Check out my post on a fund that has outperformed the S&P 500 since 1991 with much less risk.

    http://www.shortroadtoretirement.com/2012/03/possibly-greatest-mutual-fund-of-all.html

    Reply
  6. JT

    The 2/20 fee schedule isn’t as bad as it seems. Back in the heyday, hedge fund managers might have gotten 2/20 without a problem. Today, a competitive environment means hedge funds have to scale down the 2%, and the 20% is either reduced or charged only on returns in excess of the benchmark. For example, you get charged 20% on all returns higher than the S&P500 index.

    I find Warren’s bet kind of funny, since he was essentially a hedge fund manager in his best performing years.

    Reply
  7. White Coat Investor

    Warren Buffett’s winning bet is no surprise to Bogleheads. Index funds work just as well for 1%ers as for the rest of us.

    Reply

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