Hedge Funds Misrepresented

Amanda Jones: So, do you always bring an extra girl when you go out?
Keith Nelson: I like to cover my bets.
Amanda Jones: That's very cute. I'll have to remember that.
--Some Kind of Wonderful

WSJ article today touts a $1 million bet that Warren Buffett made 10 yrs ago that index funds would outperform hedge funds over a decade long period. The article suggests that, unless markets crash this year, then Buffett will win the bet.

But it is precisely during those periods of market turbulence that hedge funds outperform. The primary purpose of hedge funds, classically defined, is to 'hedge' bets with positions that move in opposite directions.

The article, which reads like an advertisement for Warren Buffett with graphics like the above, ignores the hedging purpose of hedge funds in what has transpired during the period of the bet.

Am pretty sure that the basket of hedge funds employed in the bet significantly outperformed Buffett's Vanguard S&P Index fund during the first two years of the bet. After all, this was the period during which the credit market collapse brought major stock indexes down by more than half.

Since then, however, markets have gone straight up with little correction, with many stock indexes more that quadrupling from their March 2009 lows. Major indexes currently rest at all time highs.

Basic market axiom: Long/short funds will generally under perform long-only funds in trending bull markets.

Yes, hedge fund fee structures are higher than passive index fund alternatives. But those fees have been declining due to competition. Moreover, the gains obtained from hedge funds during periods of market turbulence have far exceeded the fees.

We can be confident in this: If the last decade resulted in eight down stock market years and only two up (rather than the opposite), then Buffett would be the one getting ready to write the check.