This is a special guest post by Robert R. Johnson, Ph.D., CFA, CAIA . He is the President and CEO of The American College of Financial Services. The American College was founded in 1927 and has approximately 24,000 students enrolled in various programs. The College has provided professional education to more than 20% of the personal financial advisors, planners, insurance managers and wealth managers in the United States today. The blog post is based on his latest book – Invest with the Fed – published by McGraw-Hill and co-authored by Gerald Jensen of Northern Illinois University and Luis Garcia-Feijoo of Florida Atlantic University. He is also co-author of the books Investment Banking for Dummies and Strategic Value Investing: Practical Techniques of Leading Value Investors.

A recent Barron’s article entitled “Interactive Brokers Offers New Take on Robo Advisers” (May 1, 2015) addresses bringing hedge funds to individual investors through its Covestor platform and is touted as a democratization of the hedge fund industry. This development allows Interactive Broker’s customers to choose a hedge fund manager to invest some of their funds. In most cases, having a broader investment opportunity set is an advantage to investors. Who can argue against additional choices for investors, particularly one that brings the talents of the Masters of the Universe to Middle America?

With roughly 50,000 of my closest friends, I attended Woodstock for Capitalists this past weekend – the Berkshire Hathaway Annual Meeting. During the six hours of questions from shareholders, the Oracle of Omaha updated his flock on the status of his bet with Protégé Partners (see http://longbets.org/362/) . Simply put the bet was “Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”

S&P 500 vs hedge funds

If the bet was a prize fight, the referee would step in and stop it. The index fund has returned 63.5 percent, while the hedge funds have returned a paltry 19.6 percent. On an annual basis, the S&P has bettered the hedge fund managers in every year with the exception of the very first year. So, even considering that the S&P started out in a substantial hole the first year, it seems that the S&P tortoise is lapping the hedge fund hare. Referring to the fees hedge fund managers have received, Buffett was quoted at the meeting as saying “The hedge fund managers have done very well over that period.” He added, “The investor in the hedge funds have paid a very big price.”

Buffett’s contention was validated in a New York Times article entitled “For Top 25 Hedge Fund Managers, a Difficult 2014 Still Paid Well” (May 4, 2015). The article detailed that a composite index of 2,200 hedge funds returned only 3 percent on average while the passive S&P index returned 13.68 percent. And, only half of the top earners recorded returns that exceeded the S&P 500. Good work if you can get it.

[drizzle]If nothing, hedge funds are remarkable in their marketing prowess. To the layperson the term hedge means “something that provides protection or defense.” However, there are many varieties of hedge funds that certainly don’t provide risk reduction but, in fact, take very concentrated risks. Despite their poor performance, money is still flowing into these investment vehicles that enrich the managers and disappoint the investors.

Offering the services of hedge fund managers to the masses is not a development to be celebrated. In my view it is simply a vehicle for a wealth transfer from Middle America to the very top of the compensation pyramid. Individual investors would be well served to listen to the advice of John Bogle and Warren Buffett.

Hedge Funds For The Masses?: Let's Hope Not

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