Warren E. Buffett made a friendly bet four years ago that funds that invest in hedge funds for their clients couldn't beat the stock market over a decade.
So far, he is winning.
The wager, which began Jan. 1, 2008, pits the billionaire against Protégé Partners LLC, a fund of hedge funds co-founded by Ted Seides and Jeffrey Tarrant.
Protégé built an index of five funds that invest in hedge funds to compete against a mutual fund from
The Vanguard Group Inc. that tracks the S&P 500. The winner's charity of choice gets $1 million when the bet ends Dec. 31, 2017.
The Vanguard fund's low-cost Admiral shares returned 2.2%, with dividends reinvested, from the start of the bet through Feb. 29, as stocks rebounded from a 12-year low in March 2009. The hedge funds fell about 4.5%, based on Protégé's index returns for the first three years and results since then for the Dow Jones Credit Suisse Hedge Fund Index, which has been roughly tracking the group of unidentified funds when adjustments are made for extra fees.
“Hedge funds of funds have underperformed because of high fees and mediocre manager selection,” said Brad Alford, head of Alpha Capital Management LLC, who in January 2011 opened a mutual fund of funds designed to replicate the performance of hedge funds, only with lower charges and the flexibility for clients to pull money out daily.
Neither Mr. Buffett nor Scott Tagliarino, a spokesman for Protégé, would comment on the bet's progress.
ASSETS DECLINE
Funds of funds have seen clients flee in the past five years. Some of the largest U.S. public pension funds, including those in Massachusetts, New York and South Carolina, have started investing directly in hedge funds, instead of going through an intermediary, in an effort to reduce fees and boost returns.
The amount of money that they controlled fell by about one-fifth to $630 billion at the end of last year, compared with a year-end peak of $780 billion in 2007, according to Hedge Fund Research Inc. Funds of funds were the industry's biggest investors in 2007, holding about 43% of assets.
Mr. Buffett's argument, as with the large pension funds, is that funds of hedge funds cost too much, according to a statement that he posted on longbets.org, a website backed by the nonprofit Long Now Foundation, which fosters “long-term thinking.” In addition to the 2% management fee and 20% performance fee that hedge funds typically charge, the funds of funds add another layer of fees, on average 1.25% of assets and 7.5% of any gains, according to data compiled by Bloomberg.
WHEAT FROM CHAFF
In its statement, Protégé said that because hedge funds can make bets on rising, as well as falling, prices of stocks, bonds, currencies and commodities, they are able to beat the S&P 500 even after fees. Sophisticated investors such as fund-of-funds managers “with the ability to sort the wheat from the chaff” will earn returns that amply compensate for the extra costs, according to the statement.
The returns of Protégé's index from 2008 through 2010, reported in Fortune magazine a year ago by longtime Buffett friend and chronicler Carol Loomis, are similar to those of the Dow Jones Credit Suisse Hedge Fund Index, after adjusting for the added fees charged by hedge funds of funds. That index fell 2.5% last year and rose 4% in the first two months of 2012.
Protégé took the lead in the first year of the bet as its fund-of-funds index lost 24% and Vanguard's fund declined by 37%.
Mr. Buffett narrowed the gap in subsequent years.
The S&P fund returned 27% in 2009, compared with a gain of 16% for the hedge funds, according to Fortune. The stock fund rose 15% in 2010 as the hedge funds advanced 8.5%.
Mr. Buffett, who is chairman of holding company Berkshire Hathaway Inc., ended last year neck and neck with the Protégé funds as the Vanguard fund climbed by 2.1% and the Protégé hedge funds lost about 3.75%.
The first two months of this year pushed the Vanguard fund ahead as stocks returned 9%, more than twice the gains of hedge funds.
Mr. Buffett, who told Loomis in 2008 that he placed his chances of winning at 60%, originally suggested a bet against single-manager hedge funds.
SLUMPING SHARES
Had he found a taker, he would be trailing by about 6 percentage points, based on the Dow Jones Credit Suisse Index.
If Mr. Buffett had bet the returns of his own holding company against the performance of hedge funds, he would be even farther behind. Berkshire Hathaway shares have slumped almost 17% since the end of 2007.
