Many of my graduating high school students eventually land careers in finance.  That’s where the money is.  I live in Singapore, one of the world’s largest banking districts, so their aspirations make sense.  A rich private school, one block from Wall Street, would see much the same thing.

A couple of years ago, one of my former students came back to visit. He told me he was going to be a hedge fund manager.  “Are you sure?” I asked.  “Do you really want to charge people 2 percent per year plus 20 percent of the fund’s profits?”  I expected his face to fall. But it didn’t.  “If people are dumb enough to pay, that’s their problem,” he smiled. 

Two weeks ago, the U.S. ban on hedge fund advertising was lifted.  You might start seeing them advertised through television, radio and the Internet.  My ex-student’s mug might grace the odd advertisement.  But recognize what a disaster these products are.

Hedge Fund Returns vs. 60% Stock Index/40% Bond Index
Hedge Fund Graph

Hedge funds are like actively managed mutual funds for the Gucci, Prada, Rolex set. To buy a hedge fund, you must be an accredited investor—somebody with a huge salary or net worth.  Hedge fund managers are whispered to be the best professional investors in the industry.  They certainly have plenty of flexibility. Not to mention abundant incentive. A hedge fund (so the sales pitch goes) has the ability to make money during rising and falling markets.  Managers can invest in any asset class they desire; they can even bet against the stock market. Doing so is called “shorting the market” where a fund manager bets the markets will fall, then collects on the bet if they’re right.

Warren Buffett, however, doesn’t believe people can predict such stock market movements, charge high fees to do so, and make investors money.  He even said he would bet a million dollars that nobody could pick a fund of hedge funds that would beat the S&P 500 index over a decade.

In 2008, New York asset management firm Protégé Partners picked up the gauntlet. They selected five hedge funds with solid management and great track records.  These are the kinds of funds you’ll see touting their magical market beating abilities. But historical results are rarely future prologues.  And once again, wisdom and experience triumphed over hope (or hype).  From 2008 to 2012, Protégé’s pet funds rose just 0.13 percent.

If these hedge fund managers could have foreseen the stock market crash of 2008, they would have made a fortune by shorting the market.  They would have made Buffett look silly.  But that didn’t happen.  Five years into Buffett’s bet the stock market index was thumping Protégé’s handpicked hedge funds by nearly 9 percent.

As of this writing, a few years remain on the bet.  But if you’ve read Simon Lack’s book, The Hedge Fund Mirage, you would place your money on the index.  Lack revealed that a portfolio balanced between a U.S. stock index and a U.S. bond index would have beaten the typical hedge fund in 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, and 2011. 

Between 2003 and 2011, they underperformed a balanced index of stocks and bonds by an amount larger than the fees they charge.  In other words, the typical hedge fund manager could have worked for free, charging nothing to investors, while still underperforming a portfolio of index funds.

Hedge funds continued to disappoint hopeful investors in 2012. The HFRX index (a compilation of hedge fund returns) earned just 2.49 percent in 2012, compared to 16.0 percent for the S&P 500 index and 11.49 percent for a balanced index.  As I write, the cumulative brilliance of global hedge fund managers are also getting thumped in 2013:  gaining just 3.63 percent (to September, 2013) compared to 8.76 percent for the balanced U.S. index and nearly 20 percent for the S&P 500.

Between 2003 and 2013, hedge fund managers underperformed the S&P 500 index.  They also trailed Vanguard’s balanced index (of stocks and bonds) by roughly 75 percent, while taking massively greater risk.

As for my former student, I tried to teach ethics.  But based on his chosen profession, the lessons didn’t take.