Back in 2008, Warren Buffett (Trades, Portfolio) placed a bet with Protégé Partners LLC. Buffett and his business partner Charlie Munger (Trades, Portfolio) made a $1 million bet that a selection of hedge funds could not outperform the S&P 500 over 10 years.
By the end of 2016, it was clear who had won. At the end of 2016, Buffett's index fund bet had gained 7.1% per year, compared to 2.2% per year for Protégé's picks.
I think this outcome deserves further analysis to understand why hedge funds performed so poorly compared to an index fund. After all, some hedge fund managers have become incredibly wealthy over the past few decades. If it were always the case that hedge funds did not match the performance of the market, no one would invest in them., right?
Top-performing funds
Some hedge funds have successfully outperformed the market year after year. Maverick Capital's flagship fund has returned 12% annually after fees since inception in March 1995. The S&P 500 has returned just 10.6%. Maverick's long-only fund has returned 13% per annum.
Meanwhile, TCI Fund Management has returned 18% a year net of fees since its inception in 2014. Other legendary funds such as Baupost and Renaissance Technologies' famed Medallion fund are rumored to have produced annualized net returns of between 20% and 30% over the past few decades.
One of the main criticisms of hedge funds is the fact that they charge hefty fees. The standard 2% management fee and 20% performance fee eat away at investors' returns when profits surge and exacerbate losses in periods of underperformance.
What's more, these are only standard fees. Some funds charge 3% or more in annual management fees and 30% in performance fees. Then there are pass-through costs, costs that are not accounted for in the management fee but are charged to investors. These charges can increase the overall annual cost to 5% or more. I should note that none of these costs and charges are standard. Every hedge fund will have a different charging structure.
However, sometimes it is worth paying these fees. As I highlighted above, some hedge funds have outperformed the market over the past few decades. The sector's performance was particularly notable last year and in 2008. In 2008, Buffett's index fund lost 37.0% of its value, compared to the hedge funds' 23.9% loss. Meanwhile, the 20 best-performing hedge fund managers of all time made $63.5 billion for investors during the Coronavirus-driven market turmoil in 2020.
Investor takeaways
So what does this all mean for the average investor? Most individual investors cannot invest in hedge funds, and many of the top-performing funds outlined above are closed to new investors anyway.
For a start, it is essential to pay attention to fees. This is relevant to mutual funds, ETFs, individual brokers and index funds. Indeed, I have seen some index funds charging 2% a year.
I think it is also essential to know that while industry headline figures show the overall trend, they do not show what is happening on an individual basis. Investors looking for mutual funds to own may read that the industry underperforms on average, but there are funds out there that have outperformed.
Finding the best funds or ETFs is not necessarily about chasing performance. It is about understanding the strategy employed by the managers. In the hedge fund world, there are a lot of copycat funds, which don't have any unique strategies. It is the same in other sections of the market. Different funds can be used for various purposes, including hedging and reducing volatility.
Overall, while Buffett's bet did prove that the hedge fund sector in aggregate does not always deserve its fees, the lesson investors should take away from all of this is that sweeping generalizations are dangerous when choosing investments. One should always make their own investment decisions based on their own requirements and analysis of risks.
