At the onset of the global financial crisis almost a decade ago, billionaire Warren Buffett made a bet with Ted Seides, head of hedge fund Protege Partners whether a passively managed index fund can outperform actively managed hedge funds.
After nine years, the S&P 500 fund picked by Buffett has gone up 85.4 percent. By contrast, Protege’s five hedge fund picks have returned between 2.9 percent and 62.8 percent, trailing far behind.
Hedge funds are supposed to be managed by the world’s smartest managers and each decision is made through intensive discussion.
Hedge fund managers also enjoy great flexibility. For instance, they can freely select stocks they like. They can also keep more cash during a market downturn.
There seems to be no reason why hedge funds would lose to relatively simple index-tracking funds.
“Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the fourth law of motion: For investors as a whole, returns decrease as motion increases.” Buffett said.
If an experienced investor smelled something wrong and opted to increase his cash position, that could boost his performance temporarily.
But the question is would the investor knows when to get back into the market? So there is a good chance he would have missed the subsequent rally after the crisis was over.
Getting the timing right proved to be far more difficult than imagined.
The 2011 European debt crisis may also have something to do with the underperformance of hedge funds, as some of them may have underinvested for fear of more crises and thus missed the best part of the bull market cycle in recent years.
By contrast, index funds are not affected by emotions or judgments. They are always 100 percent invested.
The other difference is cost. Index funds do not engage in frequent buying and selling. Transactions costs are much less.
Buffett reckoned investors have wasted more than US$100 billion in paying fees to high-priced advisers over the past decade.
That said, not all index funds are good. Had one invested in funds tracking the Hang Seng Index, which is still well below the peak in 2007, he certainly would not be pleased with the result.
This article appeared in the Hong Kong Economic Journal on Mar. 1
Translation by Julie Zhu
[Chinese version 中文版]
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