Warren Buffett vs. hedge funds: Our view

Rich people tend to get investment opportunities unavailable to the rest of us. One of those is the chance to put their money into hedge funds, many of which require multimillion dollar minimums.

Sounds unfair to the little guy, but guess what? Mounting evidence shows that hedge funds are a bad bet. Don’t just take our word for it. Ask billionaire superinvestor Warren Buffett.

A decade ago, the Berkshire Hathaway CEO proposed a friendly wager that a simple stock index fund could beat a handpicked portfolio of hedge funds over 10 years. What surprised Buffett was how few people would sign up to take him on.

Out of thousands of headstrong hedge fund managers who’ve made fortunes touting their investment acumen, only one — a man named Ted Seides — was willing to put his money where his mouth was.

Given this lack of interest in the bet, the results should come as no surprise. Buffett’s entry, Vanguard’s 500 index fund, which merely buys stocks in the Standard & Poor’s 500, has increased by 85% while the Seides hedge funds are up just 22%.

The truth is, the track record of hedge funds has been dismal, and for multiple reasons.

In their effort to differentiate themselves from the masses, hedge funds take dubious risks. They frequently buy on momentum, pile into a few stocks, and convince themselves that they can make companies more profitable by pressuring their managers to make changes.

But their biggest fault is that they demand such high fees that they can’t possibly beat, or even match, markets over time. Buffett is winning in part because 60% of the gains made by Seides’ funds over nine years went to unspeakably large fees.

While some hedge funds  have lowered their fees slightly in recent years, the industry standard has been “two and twenty” — 2% of assets under management plus 20% of profits over a preset benchmark. Not even including the fee on profits (if there are any), the 2% amounts to 40 times as much as the 0.05% that Vanguard charges its biggest clients on its S&P 500 in index fund.

Those fees compound over time. Buffett estimates that the pension funds, college endowments and wealthy individuals that are the main patrons of hedge funds have squandered $100 billion over the past decade.

There are signs that investors are catching on to the hedge fund racket. Last year, more than 1,000 hedge funds were liquidated, and last month came news that the high-profile Eton Park Capital Management LP is closing.

Hedge funds argue that they will naturally underperform in sustained bull markets such as the one that has occurred since early 2009. There is some truth to that. A standard mutual fund only bets for things, such as stocks and bonds. Hedge funds often make bets against things through short contracts, put options and various other derivatives.

If stocks and bonds go nowhere but up, as they largely have over the past eight years, all this hedging is lost money. In down markets, however, hedge funds often outperform broad market indexes.

How much hedging investors should do is an open question. Stocks go up in value a lot more than they go down. Making money from pessimism is a lot harder than making it from optimism.

Whatever investors decide, they should not pay someone in excess to do so. Huge institutional investors can buy their own hedges.  Less sophisticated investors should either demand much lower fees or stay out of the hedging business.

The two-and-twenty fee structure has been very, very good for hedge fund managers. For investors, not so much.

USA TODAY’s editorial opinions are decided by its Editorial Board, separate from the news staff. Most editorials are coupled with an opposing view — a unique USA TODAY feature.

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