Morgan Housel, author of The Psychology of Money, once made this observation: “Before the 1700s, the richest members of society had among the shortest lives—meaningfully below that of the overall population.”
It was counterintuitive, but Housel cited a hypothesis, developed by historian T.H. Hollingsworth, to make sense of it: “The best explanation is that the rich were the only ones who could afford all the quack medicines and sham doctors who peddled hope but increased your odds of being poisoned.”
Housel then added this thought: “I would bet good money the same happens today with investing advice.” Wealthy folks, in other words, are lured into “fancy” investments like hedge funds that, in Housel’s view, don’t serve investors well.
The performance of hedge funds is perhaps best illustrated by a bet made in 2007 between Warren Buffett and a hedge fund manager named Ted Seides: Buffett bet that, over the course of 10 years, a simple index fund tracking the S&P 500 could outperform any hedge fund or group of hedge funds. For his side of the bet, Seides chose five funds-of-funds. These are funds that invest in a diversified group of other funds.
The hedge funds ended up trailing for nine of the 10 years, and Seides ended up throwing in the towel before the 10-year mark, writing that, “for all intents and purposes, the bet is over.”
In his 2017 annual letter, Buffett summarized the results: Over the course of the 10 years, the S&P 500 returned, on average, 8.5% per year. In contrast, the group of hedge funds returned just 3.0% per year.
These numbers pose a conundrum, though, since many university endowments are perceived to have done well with hedge funds, private equity and other private fund vehicles. If they work for endowments, why would these same investments not work for everyone else?
David Swensen, who for 36 years was the manager of Yale University’s endowment, provides the best explanation. When Swensen joined Yale in 1985, the endowment was invested traditionally—mostly in stocks and bonds. But over time, Swensen developed a new strategy, one that leaned heavily on hedge funds and other private vehicles. This new strategy delivered strong returns, and in 2000, Swensen wrote a book titled Pioneering Portfolio Management, which was a sort of cookbook for other fund managers who wanted to do the same thing.
A few years later, Swensen wrote a second book, titled Unconventional Success, with the goal of providing individual investors a formula for applying the ideas he’d developed at Yale. The project took an unexpected turn, though. As Swensen began looking at the numbers, he realized that the private fund strategy he’d developed for endowments wouldn’t work for individuals, for a number of reasons.
First is access. Owing to their partnership structure, hedge funds are limited to just 500 investors. Because of that cap, they have to be selective, so it only makes sense that for those limited slots, they’d choose the investors who could write the largest checks. And while all funds face this same constraint, the funds that can be the most selective are the ones with the best performance. The result: In general, only funds with lower-tier performance are open to individual investors.
This problem is compounded by the fact that there’s a wide gap between the best and the worst funds in the world of private investments. According to a study by consulting firm McKinsey, the difference between the best and worst among private funds is much greater than the difference among publicly-available investments like mutual funds and exchange-traded funds (ETFs).
Fees are another issue. To appreciate the impact of private fund fees, we can compare the fees on a typical S&P 500 index fund to those imposed by the average hedge fund.
Vanguard’s S&P 500 fund charges a management fee of 0.03% per year and no performance fee. Over the 10-year period of the Buffett-Seides bet, what would an investor have paid to a hedge fund?
In effect, private funds charge investors two separate fees, known as “2 and 20.” The first component is the management fee, which is usually 2%. On top of that, most hedge funds collect 20% of the profits, known as the performance fee. During the 10-year period of the bet, the S&P 500 returned 8.5% per year, so the performance fee would have added another 1.7% (20% x 8.5%), for a total of 3.7%. The hedge funds, in other words, would have charged 120 times more than the index fund (3.7% vs. 0.03%) to manage the same set of investments.
This was a key reason why Buffett felt confident in betting against hedge funds. “Performance comes, performance goes. Fees never falter,” Buffett wrote. In reflecting on the results, Seides didn’t disagree on this point: “[Buffett] is correct that hedge-fund fees are high, and his reasoning is convincing. Fees matter in investing, no doubt about it,” Seides wrote.
Taxes are another key consideration with hedge funds. While they pursue diverse strategies, in general, hedge funds are all trying to beat the market. As a result, what they have in common is that they trade frequently. And that almost always translates to tax-inefficiency.
Taxes generated by hedge funds also tend to be unpredictable, varying in relation to the fund’s trading results each year. For high net worth investors, who are most vulnerable to higher tax brackets, hedge funds tend to make tax planning an uphill battle.
If hedge funds weren’t a good fit for individual investors, what did David Swensen recommend? “Instead of pursuing ephemeral promises of market-beating strategies, individuals benefit from adopting the ironclad reality of market-mimicking portfolios…” In other words, index funds.
