Warren Buffett is so thoroughly convinced that high-cost actively managed mutual funds cannot consistently beat low-cost index funds that he bet $1 million on it! Now that’s putting your money where your mouth is.
Buffett knows that over the long term actively managed mutual funds rarely justify their high fees with market outperformance. As a result, investors in these funds are made less wealthy, while the fund managers line their own pockets. Buffett is a harsh critic of these investments. Despite his incredible personal wealth, he often champions the cause of small investors.
So in 2008, Buffett placed a very public wager with Protégé Partners, a prestigious New York-based hedge fund manager. He bet that his simple choice of Vanguard’s 500 Index Fund (which tracks the S&P 500 index of large company stocks) would outperform Protégé Partners’ hedge funds over a 10 year time frame, net of expenses.
Well, six years in, the hedge funds are getting trounced. Buffett’s Vanguard 500 Index Fund has earned a net 44%, while Protégé Partners’ hedge funds have eked out only a measly 12%. Protégé Partners’ CEO was recently quoted as saying, “We’ve got our work cut out for us.”
I’m not sure if that will qualify as the understatement of the year, but it’s definitely in the running!
You might be surprised, even shocked, to learn that for their often mediocre or worse performance, hedge funds employ a very expensive fee structure called “2 and 20.” What this means is that they charge 2% of your invested balance every year regardless of performance, and on top of that another 20% of any profits your investments earn. So if you earned, say, 6% in a given year, they would take roughly half of that away from you in fees, leaving you with a measly 3%.
To make matters worse (and even more outrageous), if there is a year in which they lose money, they do not give back any of the 20% fee they earned on earlier profits. So if your investments earned $10,000 one year and lost $10,000 the next, along with charging you their fixed 2% of invested capital both years, they would collect 20% of the profits in Year 1 ($2,000) and pay none of that back to you in Year 2 when they lost it all back! Your investments earned a net profit of zilch over the two year time frame, and yet they collected $2,000 in fees on the “profits!” Huh?
Oh, and by the way, had you instead invested in a low-cost index fund, they charge only about .1% per year on your invested balance, and nothing for the profits earned. So if your investments in this fund earned 6% in a given year, you would get to keep 5.9%.
You might ask why anyone would invest in hedge funds. Well, a very few hedge funds do quite well, not necessarily because they are smarter than everyone else, but probably often due to the law of large numbers. If enough people engage in any given activity, such as playing slot machines, some will have unusually favorable results just because so many people are participating. I’ll admit that a very small number of hedge fund managers may actually have superior stock picking expertise, but then the problem is that these funds are usually only available to extremely wealthy and well-connected investors.
Most hedge funds have average to weak performance, and they charge you an “arm and a leg” for it.
So if any of you plan to invest in a hedge fund, can you do me a favor? Rather than doing so, please instead give me a call. I’ve got some swampland in Florida I’d like to sell you at a low, low price, just for you, because you are so special!