US$1m bet: Funds that invest in hedge funds can't beat the stock market
(NEW YORK) Warren Buffett made a friendly bet four years ago that funds that invest in hedge funds for their clients couldn't beat the stock market over a decade. So far he's winning.
|Winning: Mr Buffett's Vanguard fund returned 2.2% from the start of the bet in 2008 while hedge funds fell 4.5%. His argument is that funds of hedge funds cost too much|
The wager that began on Jan 1, 2008, pits the Omaha, Nebraska, billionaire against Protege Partners, a New York fund of hedge funds co-founded by Ted Seides and Jeffrey Tarrant. Protege 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 US$1 million when the bet ends on Dec 31, 2017.
The Vanguard fund's low-cost Admiral shares returned 2.2 per cent, 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 per cent, based on Protege'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.
'Hedge funds of funds have underperformed because of high fees and mediocre manager selection,' said Brad Alford, head of Alpha Capital Management in Atlanta, who opened a mutual fund of funds in January 2011 designed to replicate the performance of hedge funds, only with lower charges and the flexibility for clients to pull money out daily.
Funds of funds have seen clients flee in the past five years. Some of the largest US public pension funds, including those in Massachusetts, South Carolina and New York, started investing directly in hedge funds instead of going through an intermediary in an effort to reduce fees and boost returns.
The amount of money they control has fallen by about one-fifth to US$630 billion as of the end of 2011, compared with a year-end peak of US$780 billion in 2007, according to Hedge Fund Research.
Mr Buffett's argument, like the large pension funds, is that funds of hedge funds cost too much, according to a statement he posted on longbets.org, a website backed by the non-profit Long Now Foundation that fosters 'long- term thinking'. In addition to the 2 per cent management fee and 20 per cent performance fee that hedge funds typically charge, the funds of funds add another layer of fees, on average 1.25 per cent of assets and 7.5 per cent of any gains, according to data compiled by Bloomberg.
Protege said in its statement that because hedge funds can make bets on rising as well as falling prices of stocks, bonds, currencies and commodities, they are able to beat the S&P 500 even after fees, and that sophisticated investors such as fund-of-fund managers 'with the ability to sort the wheat from the chaff' will earn returns that amply compensate for the extra costs.
The returns of Protege's index from 2008 through 2010, reported in Fortune magazine a year ago by long-time Buffett friend and chronicler Carol Loomis, are similar to those of the Dow Jones Credit Suisse Hedge Fund Index, after adjusting for the added fees charged by hedge fund of funds. That index fell 2.5 per cent last year, and rose 4 per cent in the first two months of 2012.
Protege took the lead in the first year of the bet as its fund of funds index lost 24 per cent and Vanguard's fund declined by 37 per cent. Mr Buffett narrowed the gap in subsequent years. The S&P fund returned 27 per cent in 2009, compared with a gain of 16 per cent for the hedge funds, according to Fortune. The stock fund rose 15 per cent in 2010 as the hedge funds advanced 8.5 per cent.
The 81-year-old Mr Buffett, who is chairman of the holding company Berkshire Hathaway, ended last year neck and neck with the Protege funds as the Vanguard fund climbed by 2.1 per cent and the Protege hedge funds lost an estimated 3.75 per cent.
The first two months of this year pushed the Vanguard fund ahead as stocks returned 9 per cent, more than twice the gains of hedge funds. -- Bloomberg