With just about one year to go, billionaire investor Warren Buffett is almost certain to win his decade-long bet that a basket of hedge funds would fail to keep pace with an S&P 500 Index fund.
Stock picking and market timing are two basic ways hedge funds can outperform index funds. And both are becoming increasingly difficult to get right.
If a hedge fund has missed the opportunity to go short during the huge declines in 2008, its chances to beat the index would be greatly diminished.
On picking stocks, the business environment is also making it harder for hedge funds. In a global economy driven by internet and tech behemoths, the winner-take-all pattern in this sector means the big ones get bigger.
As a company gets stronger and its share prices higher, its market capitalization grows and so will its weighting in the index. Funds tracking the index will then benefit.
But actively managed funds hoping to identify companies that can grow into business titans over time will be hard pressed to find enough such potential candidates.
Looking forward, investors are likely to pour more capital into index funds, so what are the implications for hedge fund managers?
One area of particular interest is medium-cap firms that are leaders in some lesser-known industries. Given the narrow focus of their businesses, they are less susceptible to competition from big firms.
One such firm is Mettler-Toledo International (MTD), which has grown into a US$10 billion S&P 500 constituent. It is a supplier of weighing instruments for use in laboratory, industrial, packaging, logistics and retailing sectors.
Tracking companies that are approaching the threshold to become an index component could be very rewarding.
Meanwhile, costs of hedging against market downfalls should also be kept to a minimum through ways like buying out of the money put options.
In a world flush with capital, there are always people waiting to buy assets on the cheap. This tends to shorten the duration of market corrections.
Unless a hedge fund can find an opportunity to short the market when a correction has just begun, it might as well look for chances to shop bargains during downturns.
This article appeared in the Hong Kong Economic Journal on Feb. 28
Translation by Julie Zhu
[Chinese version 中文版]
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