Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Just more than nine years ago, Ted Seides, managing partner of Hidden Brook Investments LLC, bet Warren Buffett $500,000 that five funds of hedge funds would collectively beat the S&P 500 over the next decade.

That 10-year bet is up at the end of the year, but Seides has already conceded. Barring a calamitous meltdown for the S&P 500 between now and December, Buffett will win.

In fact, Buffett has already taken a victory lap. At Berkshire Hathaway’s annual meeting on Saturday, he told his faithful that hedge fund managers get paid gobs of money to sell gullible investors on the idea that hedge funds can “do something magical.”

Unfortunately for Seides, there hasn’t been much magic in hedge funds recently. In a Bloomberg View column last week, Seides offered six excuses -- er, reasons -- why he lost the bet. For those who found them somewhat perplexing, I offer the following translations.  

No. 1. Price matters … eventually (Translation: The S&P 500 had no business beating hedge funds!) Seides points out that the S&P 500 was expensive -- and therefore its expected return was muted -- when he and Buffett shook on the bet in January 2008. It’s true that the S&P 500’s cyclically adjusted price-to-earnings, or CAPE, ratio was 26 at the time, which was much higher than its historical average CAPE ratio of 16.3 since 1881.

But that’s only half the analysis. There was good  reason to suspect that hedge funds were frothy, too. When 2008 began, $1.9 trillion was invested in hedge funds, up from $39 billion in 1990. The HFRI Fund Weighted Composite Index had returned 13.8 percent annually over that period. Those numbers implied that hedge fund returns would be much more modest going forward.

No. 2. Risk matters … eventually (Translation: But hedge funds are less risky!) Hedge funds love to trumpet their risk-adjusted returns. If Seides wanted to wager on risk-adjusted -- rather than absolute -- returns, he should have said so. But it wouldn’t have helped. The Sharpe Ratio -- a common measure of risk-adjusted returns -- of the S&P 500 was 0.48 from 2008 through April, compared with a measly 0.08 for the HFRI Fund of Funds Composite Index. A higher Sharpe Ratio implies that investors are better compensated for risk.  

Dull Days
Hedge funds love to trumpet their risk-adjusted returns, but even that has failed them since 2008
Source: Bloomberg

No. 3. A passive investment in the S&P 500 is an active bet (Translation: Buffett was lucky he chose the S&P 500!) It’s true that large-cap U.S. stocks have been among the best performers since 2008. But lots of investments have beaten hedge funds over that period. For example, the Russell 2000 Index -- a collection of small-cap U.S. stocks -- has beaten the Fund of Funds Index by 7.5 percentage points annually through April. And the MSCI ACWI Index -- a collection of global stocks that includes the U.S. -- has beaten the Fund of Funds Index by 3.4 percentage points annually. So it’s not so much that the S&P 500 has gone gangbusters, but that hedge funds have been awful.    

Ways to Lose
Lots of investments beat funds of hedge funds since 2008
Source: Bloomberg
Note: Indexed to 100

No. 4. Be careful comparing apples and oranges (Translation: The bet never made sense to begin with!) It’s cheeky to say that the S&P 500 isn’t comparable to hedge funds after you lose the bet. Yes, they are entirely different investments. But it’s probably better to bring that up before you owe someone $500,000.

No. 5. In investing and in life, we live through only one experience out of many possibilities (Translation: The odds were in my favor!) See No. 1. It’s not at all clear that the expected return from hedge funds was higher than that of the S&P 500 in 2008.

No. 6. Long-term returns only matter if we invest for the long term (Translation: I really won because no one actually captured the S&P 500's return!) It’s true that many investors lost their appetite for stocks and bailed during the 2008 financial crisis. The Vanguard 500 Index Fund returned 7 percent annually over the last 10 years through April, while, according to Morningstar, the average investor’s return was just 3.1 percent annually because of poor market-timing decisions. But that’s still 2 percentage points a year better than the return from the Fund of Funds Index.

Still Ahead
The average investor has failed to capture the market's return since 2008 but still managed to beat hedge funds
Sources: Morningstar, Bloomberg

Seides is right, however, that hedge funds have a better chance of beating the S&P 500 over the next decade. The S&P 500 is even more expensive now than it was 10 years ago. Meanwhile, hedge funds have performed horribly over the last 10 years -- the Fund of Funds Index has returned just 1.1 percent annually through April. Unlike a decade ago, the numbers point to higher expected returns from hedge funds than from the S&P 500.

But if Seides is tempted to bet with Buffett again, I suggest a wager on gross returns. Hedge fund fees are exorbitant and doubly so for funds of hedge funds. No one wants to hear in 10 years that Seides would have won if only hedge fund fees were lower.

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

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

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