Markets

Michael P. Regan is a Bloomberg Gadfly columnist covering equities and financial services. He has covered stocks for Bloomberg News as a columnist and editor since 2007. He previously worked for the Associated Press.

Warren Buffett was at it again over the weekend, trolling the hedge-fund industry by telling all the groupies gathered at Berkshire Hathaway's annual meeting to avoid high-fee money managers and bragging about how he's winning his bet that a low-cost Vanguard mutual fund tracking the S&P 500 will beat a basket of hedge funds from 2008 through 2017.

It seems that hedge funds are to "the Woodstock for Capitalists" what the brown acid was to the original Woodstock for hippies: best to be avoided. And it's easy to see why because hardly a week goes by without another story of redemptions, wrong-way bets or other assorted bad trips. The fees “eat up capital like crazy,” Buffett said, according to the Bloomberg coverage, and consultants have steered pensions and other big fish to funds that have been outperformed by what you could get “sitting on your rear end” in index funds. 

This is a compelling argument because, let's be honest, people like to sit on their rear ends. It's one of the great American pastimes. And also, let's be honest, people like to hate on hedge fund managers, who appear to the nonaccredited investor class to collectively suffer from a nasty case of backpfeifengesicht because of their tendency to do things like mate way out of their league and own sports teams that the rest of us can't afford to buy tickets for, etc.   

Buffett is right that sitting on your rear end in an index fund probably is the best bet for a long time horizon. But if you are a hedge-fund investor, does it really make sense to abandon the entire "compensation scheme masquerading as an asset class" at this juncture? The answer may depend on your view of where the market is headed next, which is to say it's not an easy answer at all.

Running of the Bull
The U.S. bull market in stocks is now the second longest on record
Source: Bloomberg

Just last week, the U.S. bull market in stocks became the second longest on record, which -- fair or not -- leaves it vulnerable to some age discrimination. Over that stretch, equity hedge funds as a group have underperformed the S&P 500, which is a comparison that many fund managers will insist is apples to oranges but which nonetheless is a comparison that will probably continue to be made forever by investors perusing the fruit salad of investment options. 

Look at this chart, which shows a ratio of the HFRX Global Hedge Fund Index to a total-return version of the S&P 500. When the line is falling, it means the hedge funds tracked by the index are getting beaten by the S&P 500. And, whoa boy, it has been falling for the last seven years:

Hedge Fund Horror Show
The ratio of an index of global hedge funds to the S&P 500 has been declining since 2009
Source: Bloomberg data.

However, note how the line spiked higher from October 2007 to March 2009. In other words, hedge funds managed to outperform during the last bear market, even after fees. They also outperformed during the bear market crash after the dot-com bubble, resulting in the peaks in the chart in 2002 and 2003 as the stock market was finding its bottom. They then underperformed during the next bull market of the mid-aughts. 

The peaks and troughs are even more pronounced when looking at a ratio of equity market neutral hedge funds to the S&P 500 Total Return Index:

Neutral Territory
Outperformance by equity market neutral funds can be seen during bear markets
Source: Bloomberg

To be sure, of course, all of this may have zero meaning right now. The hedge-fund performance data only goes back about two decades. No one knows for sure if this bull market is in the ninth inning or the fourth. And who knows whether a third bear market would result in another spike of outperformance; maybe the proliferation of computerized trading and competitors in the last decade has changed the paradigm for good?  

However, it does seem to be enough to make it fair to say that the lackluster performance by hedge funds over the last few years is no guarantee that they won't outperform over the next few. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Michael P. Regan in New York at mregan12@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net