Index Funds vs. Hedge Funds

In 2008 Warren Buffett placed a bet, which essentially totaled $1,000,000, against a group of hedge funds chosen by the people betting against Buffett. Hedge funds are the go anywhere, do anything (almost), hotshot investment vehicles for sophisticated investors. His bet was that the Vanguard Index 500 (Admiral shares) would outperform this carefully selected group of five hedge funds over a 10 year period.

One of the big challenges for those hedge funds will be overcoming their expense disadvantage. Annual charges of 2.5% of the account balance are made regardless of performance. On top of that, generally hedge funds take 20% of any gains made. In a good year when your investments might grow $100,000, the hedge fund takes $20,000 of that in addition to the 2.5% annual charge on the total.

Here’s my thought: If Buffett is willing to make that kind of bet, that some of the best and brightest investment minds out there won’t be able to outperform the S&P 500 index, what makes you think you can find investments that will? If you agree, invest in broad market based index funds and go to the golf course or spend your days doing other things which might interest you more.

As of this date (2011) several hedge funds have closed their doors. Since “the bet” did not include releasing the names of the five chosen hedge funds we won’t know if any of the chosen have gone out of business or not. But, that’s another variable to consider in your investment selection and one you don’t have to worry about with good broad-based index funds.

The expense ratio on the Vanguard Index 500 Admiral Shares? It is .07% currently. That means on every $100,000 you pay $70 each year. For a hedge fund you could pay $2,500 each year on the account value at $100,000 (if they allowed you to invest that little). If the Vanguard fund goes up from $100,000 to $200,000, your total expense would be $140 for the year. A hedge fund increasing by the same $100,000 would charge you $20,000 for the investment increase and 2.5% on the account balance, roughly $22,500. Of course, if the hedge fund increases offset the expenses then you’re set. But, assuming non-offsetting underlying performance would you rather pay $22,500 or $140 in expenses for an investment?

Another nice thing about index mutual funds is, they won’t have a “lockup” period. Hedge funds may have a lockup period when you can’t access your money except at certain times (maybe quarterly or annually). Also, hedge funds do sometimes go out of business. For an example, search the Internet for “Amaranth Investors” or "Long Term Capital Management" and check their history.

Update: At the May 2, 2014 Berkshire Hathaway annual meeting, Buffett said the cumulative return of the S and P index fund has been 43.8%, while the hedge funds returned 12.5%.