One of the most common complaints I hear about hedge funds and alternative investments is that their fees are too high. The typical 2-and-20 compensation model works well for managers, people say, but what about investors? It’s today’s equivalent of the old Wall Street punch line that used to be leveled against stock brokers: “Where are the customers’ yachts?” Another complaint I hear is that hedge funds and alternatives are too risky. Are hedge funds worth the price?
It’s a question that’s generating a lot of buzz lately. For starters, there’s the contest heating up between Warren Buffett and Protégé Partners, a fund of funds in New York. Ted Seides and his partners at Protégé are betting that a portfolio of five carefully selected funds of hedge funds can return more money to investors over 10 years than the S&P 500. Buffett has his money on the S&P 500. The contest is only half over—it began Jan. 1, 2008—and Buffett just took the lead for the first time. Thanks to the stock market rally in 2012, the S&P 500 index fund Buffett chose is up 8.69% over the last five years. Protégé’s picks are up just 0.13%. Several factors determine performance including the strategy and managers, but part of the reason for lagging the index is that hedge funds often underperform in bull markets, but shine in bear markets.
This is one of the points that Seides made in an essay he wrote as his contest reached its five-year mark. Appearing in the CFA Institute’s January 2013 blog and provocatively titled, “Hedge Funds: The Most Expensive Bargain in Town,” Seides demonstrated that long-term outperformance of hedge funds versus the S&P 500 is due to their outperformance in down markets. “Outperformance on the downside is far more important to long-term returns than outperformance on the upside,” he wrote, adding that the results are the same for almost every other 10-year period since 1994.