Hedge Funds Aren’t Supposed To Beat The Market

Edit: I posted a follow-up with comments from people who disagreed with me. If you’re just curious about hedge funds, read that first.

NPR’s Planet Money podcast recently ran an episode about a bet between legendary investor Warren Buffett and Ted Seides of the hedge fund Protege Partners. In 2006, Buffett proposed a ten-year wager that an index fund would outperform any hedge fund. Seides took him up on this, and he’s lost pretty spectacularly. Currently, about two years before the deadline, the index fund is up ~65%, whereas the hedge fund is only up ~20%. In other words, the index fund has done three times as well as a bunch of smart people picking stocks. However, during the 2008 financial crisis, the index fund was down ~45% and the hedge fund was only down ~25%.

These two types of investments performed differently in different environments, demonstrating why both exist. An index fund indexes long-term economic growth. The point of a hedge fund is also right there in the name: it’s for hedging your bets. If you’re a person with a lot of money invested, it’s useful to have an account to pull from that’s rising (or at least less devastated) when the rest of the market is doing badly. That way you can access some of your funds without solidifying your losses — the rest of the money can be left to hang around and recover. If it turns out that you never need to access your invested money during a crash, having chosen a hedge fund will mean that your returns are lower than they conceivably could have been. That’s the tradeoff of mitigating liquidity risk.

The Economist explains regarding hedge funds:

“Initially, their aim was to produce a positive, or absolute, return in all markets by going short (betting on falling prices) as well as going long (relying on rising prices). For example, a hedge fund might bet on BP, an oil giant, by buying its shares, while shorting the market as a whole. The hedge provided by the short allows the firm to place a bet on a specific company while insulating the fund from the risk of taking a loss as a result of a broad decline in the market.”

The magazine goes on to point out that modern hedge funds do various other things too, but that’s the gist. Investopedia has a perfect one-liner: “Even though hedging strategies are employed to reduce risk, most consider the practices of hedge funds to carry increased risks.” Exactly. And hedge funds are too expensive to justify the opportunity cost — they don’t provide high enough returns relative to other options — unless you need to hedge liquidity risk. Warren Buffett wrote:

“A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs [read: fees] they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.”

The key phrase there is “on average and over time”. If you need to extract money at a specific disadvantageous time, having invested in a hedge fund can be useful because of its ability to short the market.

Ted Seides seems to mostly understand this:

“Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. […] For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. […] There is a wide gap between the returns of the best hedge funds and the average ones. […] Funds of funds with the ability to sort the wheat from the chaff will earn returns that amply compensate for the extra layer of fees their clients pay.”

To summarize: Hedge funds try to make money all the time, regardless of the market’s overall state, instead of riding out the downturns. Really good money managers can outperform index funds on behalf of their clients — even after you skim their fees off the top. (Ironically, that’s potentially true of Warren Buffett but demonstrably false of Ted Seides, at least over a ten-year span.) Basically, Seides is saying that the best investors can do better than average, which is sort of a tautology. The problem is that finding the best investors is very difficult, and “best” is an uncommon attribute. Most hedge funds are useful for, well, hedging, not for growing wealth.

Seides’ cogent explanation of how hedge funds work, despite eliding the obvious objection, makes it really weird that he took the bet, and even weirder that he told Planet Money that he’d take it again. On the show, Seides asserted that Buffett just got lucky, which is frankly insane. Maybe this was an oddly angled PR move for Protege Partners? Or perhaps Seides really does think that he and his ilk are exceptional money managers. The results say no, but people cling to high-prestige identities. It still seems strange to me that he believes in his ability to pick winners when the evidence shows that he can’t.

Epistemic status: I’m roughly 65% confident of my analysis. But it’s very possible that I don’t understand the vagaries of finance well enough to write any of this. Not that I would ever let that stop me! ;)

Also published on Medium.