I put on a t-shirt and a pair of loose fitting pants. I then slipped on my running shoes. At 3am, I left the Holiday Inn. It was May 6, 2005. I took a taxi down to Omaha’s Qwest Center. Dozens of eager Warren Buffett fans stood beside the door. We were there for Berkshire Hathaway’s Annual General Meeting. Many hours later, thousands filled the line. When the doors eventually opened, I ran forward hoping to get a front row seat.
We took a sharp right turn and ran through the building. I’m not a bad runner. That’s why I was surprised when a guy in a 3-piece suit began to leave me in his dust. He wore stiff dress shoes. He carried a briefcase. The guy would have looked great in a corporate boardroom. But he wasn’t built or dressed for speed.
Unfortunately, he soon tangled with another runner. The suit fell on his face. His briefcase opened. Contents scattered on the floor while the stampede ran over them. He was scrambling to his feet when I ran past. It was a perfect introduction to one of Warren Buffett’s lessons.
I found a great seat beside a guy named Chris. He ran an actively managed mutual fund. At one point Warren Buffett leaned forward after popping a couple of See’s candies in his mouth. He said, “I don’t think anybody here can pick 10 actively managed mutual funds that can beat the S&P 500 after fees over the next ten years.” I nudged Chris. He gave a sheepish look.
Actively managed funds charge higher fees. They’re a bit like runners who carry brief cases. That’s why most low-cost index funds beat them over time. But Warren Buffett saved his real wrath for hedge funds.
He summed it up in his letter to Berkshire Hathaway shareholders this year. “I publicly offered to wager $500,000 [in 2005] that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender.”
Hedge Funds are like runners who wear 3-piece suites and stiff dress shoes. They also carry cases with 20 pound loads. Most of them charge a 2 percent annual fee. They also take 20 percent of any profits earned. Because hedge funds are only available for the rich, we often think they make investors buckloads of money. But most of them don’t.
That’s why only Ted Seides, a co-manager of Protégé Partners, took Buffett’s challenge. Mr. Seides picked five funds-of-funds that would go head-to-head with Vanguard’s S&P 500 Index. That means each hedge fund contained a series of hedge funds within it. Each of those funds had (presumably) a great track record before Mr. Seides took the bet.
But when it comes to picking funds, we should ignore track records. The Wall Street Journal’s Jason Zweig says, "Buying funds based purely on their past performance is one of the stupidest things an investor can do." Morningstar’s Russell Kinnel says, “A fund’s annual fee is its best predictor of future performance.” The lower the fees the better.
Warren Buffett knew this. That’s why he championed a low-cost S&P 500 Index Fund. The bet began in 2008. Stocks crashed that year, so it should have been a great year for hedge funds. If the fund managers could have predicted the crash, they would have pulled far ahead. But that didn’t happen. In the years that followed, the S&P 500 ran like a Kenyan from a pack of pudgy men.
Only one year remains on the bet. Vanguard’s S&P 500 Index is up 85.4 percent. The hedge funds are up just 22 percent. In fact, not one of the funds of hedge funds has kept pace with the S&P 500. The best performing one (listed below as Fund of Funds C) is up just 62.8 percent.
Was Mr. Seides just unlucky? I don’t think so. Hedge Funds are expensive. Funds of hedge funds cost even more. As Vanguard’s founder, John Bogle says, the less you pay in fees, the more you get to keep.
The Hedge Fund Research site tracks the returns of hedge funds every year. They don’t count the results of funds that self-destruct. They only count survivors. That ensures an upward bias.
When Princeton University’s Burton Malkiel and Yale School of Management’s Robert Ibbotson studied Hedge Funds from 1996 to 2004, they discovered that 75 percent of the hedge funds went out of business during this eight year period. Only the funds that don’t go out of business and voluntarily report their results are available to the Hedge Fund Research site.
Even so, the results look pretty ugly. I compared the performance of the surviving hedge funds to a portfolio made up of global stocks and U.S. bonds. I started the comparison in 2002. If $10,000 were invested in the average surviving hedge fund, it would have grown to $12,330. A portfolio containing a global stock index (70%) and a U.S. bond index (30%) would have turned that same $10,000 into $27,116.
Investing with a portfolio of low-cost index funds is like running a race wearing Nikes. Such investors also wear a t-shirt and a light pair of shorts. Investors in hedge funds might look a lot better in their 3 piece suits. The heavy brief case might also add style. But as Warren Buffett proves, that’s not the way to win a long-term race.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.