Seven years ago, Protégé Partners Co-CIO Ted Seides took a $1 million bet with Warren Buffett over whether the average performance of five funds of hedge funds could beat the S&P 500 net of fees over a ten year period (the winner gets to choose which charity gets the money). The funds of hedge funds are getting crushed, but Seides draws on the value investing lingo that Buffett helped make famous for a tour de force rationalization.
“Just as stock picks sometimes head in the wrong direction upon purchase and call into question whether a thesis is early or wrong, so too has hedge fund underperformance over the last seven years raised the question of whether hedge funds are bent or broken,” he writes on the CFA institute blog.
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Funds of hedge funds are underperforming even before fees
First off, Seides isn’t just losing the bet, he’d still be losing if we only looked at gross performance, 63.5% to 44.0%; after fees it’s 63.5% to 19.6%. But now he’s complaining that factors outside his control have “wreaked havoc on a bet, the prospects of which we initially felt quite confident about,” a handy excuse for any investment that doesn’t work out.
That said, let’s run through Seides’ specific objections just to see how well he’s doing in the new pro forma bet that doesn’t actually count.
Seides paints an impossible scenario to rationalize underperformance
The S&P 500 has outperformed global markets in recent years, so Seides switches his comparison over to the MSCI ACWI, which has still done well but not quite as well as US stocks. He also adjusts for the fact that hedge funds aren’t fully exposed to market risk (isn’t that the ‘hedge’ part?), for the effect of QE on stock market returns, for the historically low interest rate environment, for the cost involved in shorting a stock, and for the increased competition among hedge funds. Finally, he treats fees as if they are some unexpected external factor instead of the reason people start hedge funds and the reason Buffett bet against them.
In other words, if we lived in a world where the macro environment is predictable, there’s not much competition, and hedge fund managers work for the satisfaction of a job well done, he’d still be in the running in his bet, assuming we take his adjustments at face value.
So even though the funds of hedge funds are underperforming, Seides wants you to know that they nearly overcome their many disadvantages, which is really close to a moral victory, which is definitely what investors are looking for.
H/T Reformed Broker