Warren Buffett has entered a bet with the principals of an asset management firm, Protege Partners, that the S&P 500 (NYSEARCA:SPY) index will outperform a portfolio of funds of hedge funds over a ten year period. Details of the bet can be found here.
Before we address the intricacies of this bet, let us emphasize the meaning of 'a portfolio of funds of hedge funds'. A hedge fund is a portfolio of securities. A fund of hedge funds is a portfolio of hedge funds. Therefore a portfolio of funds of hedge funds is a portfolio of portfolios of portfolios of securities. This layered cake of a construction suggests that Protege may not be as confident of the value-added of hedge funds as it should be.
The Right Bet
The bet should have been designed differently and in the following manner:
The bet should have taken place one level down: the S&P 500 (SPY) vs. a fund of hedge funds (instead of a portfolio of funds of hedge funds). The additional layer probably works in Buffett's favor since the more layers are added, the more fees are added, and the less important are the investment skills of individual fund managers.
The bet should have excluded hedge funds and funds of hedge funds that use leverage. If you leverage up in a positive market, you will beat the S&P 500. This way of achieving outperformance requires only a strong stomach and a good banking relationship, but no particular investment skill.
The bet should have specified that the fund of hedge funds must beat the S&P 500 index by at least 1% per year. Hedge funds and funds of hedge funds are more cumbersome investment vehicles than a simple indexed ETF or mutual fund that would mimic the performance of the S&P 500. If I invest in a hedge fund and then redeem my investment, it may take up to a year for me to get all of my money back (typically 90% of my money within 30 to 60 days of the fund manager receiving my redemption notice, and the remaining 10% after the hedge fund finishes its audit of the current year). If I invest in an indexed ETF or mutual fund, I get 100% of my money back on the same day. This difference in liquidity means an investor in a hedge fund should require a better performance than an investor in an index.
It is possible and probable that Protege will win the bet as it is presently configured. But in a true contest without leverage, and accounting for the difference in liquidity, funds of hedge funds do not earn their keep. Some individual hedge funds will consistently beat the market, but as with mutual funds, the odds of picking the right index-beating hedge funds over a ten-year period are extremely low.
For our part, we believe hedge fund returns are somewhat inflated by industry practices. In addition to the role played by leverage, we feel that the practice of charging incentive fees based on unrealized gains should be reexamined. A case should be made that fees should only be charged on realized gains. When a fund manager takes a fee on unrealized gains, he/she is in essence realizing his own share of the gains while his investors' gains remain unrealized. He has become liquid, while his investors are not. With the rising importance of hedge funds in the markets, this discrepancy can give rise to tacit collusion among hedge funds and to manipulation of securities prices around the end of each year. But taking a cut of unrealized gains is the cornerstone of hedge fund economics. Don't expect hedge funds to willingly change this rule any time soon.