Hedge Funds: Losing the Million Dollar Bet

It’s true. Big money can be made from hedge funds…if you run one, that is.

That’s the likely conclusion reached by those following the progress thus far of the decade-long “million dollar bet,” started six years ago between Warren Buffett and New York-based asset manager, Protégé Partners. Mr. Buffett now has a commanding lead with his low-priced index fund up against a collection of five hedge funds chosen by Protégé. Note that Buffett is using Vanguard 500 Index Admiral Shares (VFIAX), but per the terms of the bet, only Buffett and the managers at Protégé know the names of the hedge funds.

Both parties have agreed that the eventual winner of the bet will donate the $1 million prize to charity; Buffett’s designee is Girls Inc. of Omaha, and Protégé’s is Absolute Returns for Kids. So far, it’s looking good for the girls.

Through the end of 2013, Buffett’s index fund was up 43.8%, while Protégé’s portfolio of hedge funds was reporting a gain of 12.5% after fees. And the fees are not an insignificant consideration. Whereas Buffett’s index fund charges a mere .05%, hedge funds typically charge a 2% management fee and also take 20% of the profits, hence the moniker “2 and 20.” So, in other words, when hedge fund managers successfully generate above-market returns, they are rewarded with 20% off the top, rather than the investor reaping the full benefit.

In fact, it’s estimated that from 1998 to 2010, the hedge fund industry captured at least 86% of the returns it earned for its customers. This might explain why yachts cruising the Caribbean tend to be skippered by hedge fund managers, not investors.

There are other drawbacks to hedge funds, too, beyond the substantial fees. They are not particularly liquid, they receive a relative lack of oversight, and they bear the additional costs of leverage and derivatives.

And yet, they continue to attract investors. Of course, a high percentage of the investing public – egged on by the financial media – are eager to buy into the hype because they genuinely want to believe it is possible to consistently achieve returns that beat the market without taking on additional risk and/or paying excessive fees. And then for some, the exclusivity of hedge funds is very alluring. They are willing to pay the premium to be part of the high-net worth “club” of investors permitted to invest in hedge funds because they meet the accredited investor standard of at least $1 million in investable net worth (excluding residence) and $200,000 in income.

For those who have followed the hype surrounding hedge funds over the years, though, none of this is really a surprise. We expected Buffet’s low-priced index fund to come out ahead because we understand the long-term lessons of the market and aren’t particularly swayed by glamorous marketing ploys.

The bottom line is this when it comes to hedge funds: investors should exercise extreme caution. Their payoffs are very uncertain, their expense ratios high, and they suffer a lack of full disclosure.

Of course, starting one up and earning all those fees may be another matter altogether…But for now, in terms of building wealth with steady and solid growth, we’ll stick with Mr. Buffett’s position.