Ted Seides lost a bet against Warren Buffett (Trades, Portfolio) when he pitted a fund of hedge funds against the S&P 500 (SPY, Financial) in a 10-year race for best performance. Buffett recently reissued the challenge and did not have to wait long for takers.
Despite losing the bet, Seides is still a winner because he was not known nine years ago. His fund of hedge funds was ahead for at least three years or so. The bet garnered an enormous amount of publicity and Seides is now regularly invited to financial podcasts. Even though he lost the bet and the hedge fund industry is now widely ridiculed for not beating a "simple index," it probably helped him. This basically explains why now another “fool” is eager to take on Buffett. This time it is Mark Yusko:
While Buffett is fully aware of their agenda, he loves the bet because it generates tremendous attention for his message: buy low-cost, widely diversified Vanguard funds and just hold.
I admire Buffett for wanting to spread this message and actually agree two and 20 as a standard fee structure is not something I would love to pay for hedge fund services.
At the same time, I want to nuance the discussion a little bit. Hedge funds may not beat the S&P 500, but that does not mean you should not invest in them. Let me explain.
The S&P 500 is made up of large, mostly mature companies and, for the most part, does not go up a tremendous amount within a year and only rarely falls 20% or more. It is more or less clear what the S&P 500 consists of and historically, it delivered returns in the 9.5% to 11.4% range depending on whether you look at the arithemetic or geometric average.
On the other hand, what hedge funds are is not clear at all. This is a diversified group of specialist funds that have one characteristic in common, which is they charge high fees. They are known for two and 20 because they take a 2% management fee and 20% of any profits above a benchmark. There are activists like Bill Ackman (Trades, Portfolio) who are mostly long with the occasional short. There are long-short funds like Greenlight Capital, which sometimes have a bias toward one side. There are full market neutral funds with an equally sized long-short book. There are also funds that do this strictly with bonds. There are hedge funds that do short only and there are event-driven funds where mergers and acquisitions generally make up a portion of their activities. All these strategies have different value propositions. Sometimes they are all thrown into the alternative investments category because they generally provide returns that are uncorrelated from the general market.
Why are these bets against Buffett so terrible?
The value proposition of hedge funds is not at all that they are great for generating returns. There is no good reason to pit a number of them against the S&P 500 and watch them get destroyed. I bet many a hedge fund manager is silently steaming at the guys who are taking up these bets on onerous terms on “behalf” of the industry.
Take the value proposition of a market neutral fund. The fund invests its assets 80% long and then sells an equal amount of stocks short. When you sell stock, you get cash in return, which is also called collateral. The market neutral fund now holds an amount equal to 100% of its assets under management in cash. Of that, it did not invest 20% and 80% it got as collateral. It is now able to take this 80% and invest it in risk-free securities like short-duration treasuries.
Theoretically, the long-short fund can now return the risk-free rate with the presumed alpha - alpha meaning the stock picking skills of the manager as opposed to achieving higher returns by assuming more risk - provided by the manager added to it. This return stream is theoretically unrelated to market returns. Over the past 10 years, we have seen a risk-free rate that has been the lowest it has been in the last five milleniums. Since the collateral hedge funds receive in return for their short positions does not yield much, the effective cost of shorting is very high. No wonder they are delivering such muted returns.
Returns streams that are not correlated to other financial assets like stocks, bonds and commodities are valuable because including a slice of them within a portfolio can result in a higher Sharpe ratio for the portfolio. The Sharpe ratio measures the risk-adjusted returns of a portfolio. In practice, it means you will have fewer or more shallow drawdowns, which may allow an investor to allocate more aggressively to their investment portfolio.
There are hedge funds that are long only or with heavily long biased portfolios, but these are just a few of the strategies. It would be appropriate to race this subset against the S&P 500. For every subset you could argue different benchmarks, and that is how they often measure themselves and how their clients measure their effectiveness. Suddenly comparing them as a group against the S&P 500 does not make all that much sense.
Some of the value will only rarely be observed
Hedge funds help diversify against tail risks. I do not mean tail risk funds specifically, which is a class in itself. Tail risks almost never happen, but they have an enormous impact. Let me give a simplified and somewhat outlandish example. Remember, tail risks are by definition sort of outlandish until they do occur.
Let’s say the president of the United States decides to invade North Korea to shut down its nuclear weapon program, like it did in Iraq to stop the development of weapons of mass destruction. In turn, North Korean agents release O-ethyl S-disopropylaminomethyl methylphosphonothiolate, or VX, in L.A., San Francisco and New York, and we may see a drop in the S&P 500 without precedent. If some sort of abnormal event, it does not have to be the above, causes a 60%-plus drop, it puts stock investors far behind hedge fund investors. Even though some types of hedge funds would hold up reasonably well in such a scenario, it is not very likely to show up in the data within two decades.
To make matters worse, Seides raced a fund of hedge funds against the S&P 500. Why not pick a basket of hedge funds or an ETF of hedge funds? A fund of funds adds a layer of costs to the two and 20- as if two and 20 is not egregious enough. A fund of fund investments is worse by default and it should not reflect on the entire hedge fund community. After all, you can also invest in hedge funds directly.
Bottom line
These bets with Buffett are not what they seem. Buffett is trying to get the message across that two and 20 is a really bad deal for the common man and hedge fund people are embracing the role of villain for their five minutes of fame. From my point of view, both the S&P 500 and a fund of hedge funds are currently really bad bets. I would much rather practice my stock picking. I will gladly take my chances against either.
Dislosure: No positions.
