In 2007 Warren Buffett made a famous million dollar bet that the S&P 500 index, an investment open to anyone and requiring no management or expertise, would beat a collection of hedge funds selected by and managed by Wall Street ‘experts’ over the next 10 years. Not only did Buffett easily win the bet, it wasn’t even close.
In the past decade, the S&P has trounced hedge funds in 9 out of 10 years (see table below.) The S&P returned over 440% greater gains compared to hedge funds from 2011 through 2020 compared to hedge funds:
Why do hedge funds generate lousy returns? It’s the fees
Minimizing fees (as well as taxes) are absolutely critical to investment success, and are why I recommend low-fee index funds to my clients, and also why I charge a flat fee that is far less than the 1% of AUM that other advisors get away with. (Reach out if you need a great financial advisor.)
Hedge funds have been infamous for their ‘2 and twenty’ formula, meaning many of them took 2% of assets under management, regardless of their performance, AND 20% of any profits they generated for their clients. This disastrous formula– for the clients; the hedge fund managers love it– is the reason Buffett won his bet. It was also why he was so confident that he would win at the time he made it in 2007.
Hedge fund fees have moved very slightly downward over the past 10 years– so have index funds’ already-low fees— but they are still massively large, especially when compared to the miniscule fees charged by index funds, often under 0.10%.
The bottom line: cut your investing costs to the bone
Never hire an ‘advisor’ (aka salesperson/broker) that receives commissions to sell you high-priced products, or charges you a percentage of AUM. Instead, go with a fee-only (= no-commission) advisor who charges you a reasonable flat fee for advice and investment management, like me.
Further reading on the hedge fund manager problem
Morgan Housel from the Motley Fool wrote this humorous article called ‘Two hedge fund managers walk into a bar‘ detailing the paradox of hedge fund managers’ brilliance compared to their awful returns. (It’s not really a paradox at all, it’s a simple agency problem: what’s good for high-fee money managers is bad for investors, and always has been.)