Ten years ago, Berkshire Hathaway CEO Warren Buffett made a bet with a hedge fund manager that the S&P 500 would outperform a certain group of hedge funds in the next decade. The results were somewhat surprising; his S&P 500 fund experienced an annual gain of 7.1% over ten years, while the basket of funds selected by the hedge fund manager only experienced an average increase of 2.2%.
The victory was finalized in January, and Buffett won $1M from the bet. The proceeds will go to Girls Inc. of Omaha, Nebraska, a non-profit dedicated toward female youth empowerment. But what made Buffett so confident that hedge funds would underperform? The answer is in the issues that have gradually surfaced surrounding hedge funds going forward. Here are three reasons why hedge funds are becoming less attractive to the investor:
The first issue is decreased returns due to increased competition, which we’ve seen in the post-recession boom. It’s relatively easy for a hedge fund to beat the market when there are ten hedge funds in the country, but things become more complicated when you have somewhere around ten thousand. This may get worse before it gets better. Most of these funds use similar strategies, buy similar investments, and as a result we’ve seen strongly decreased returns. A strategy is only valuable if very few people have it or understand it; once the strategy becomes overcrowded, it yields mediocre returns.
Hedge funds are extremely variable and hard to predict. A hedge fund which dominated last year may have significant losses this year, considering that it is difficult to apply a single strategy in a highly dynamic market, where the environment is subject to change. With a few exceptions such as Bridgewater, Renaissance Technologies, etc., basically every hedge fund has been nearly as risky as the market, and many have generated sub-zero returns. In the end, it becomes just as difficult for an individual or institution to select a strong hedge fund as it is to pick a strong stock. Major funds are often too large to consistently yield spectacular returns, and have proven to be equally susceptible to collapse; small funds, on the other hand, typically require higher fees due to a low value of assets under management (AUM).
Lastly, hedge funds have received heat due to their “2-and-20” structure, where funds take fees from profits, but not from losses. The structure entails a flat 2% fee from total assets under management (AUM) in addition to a 20% fee of the fund’s profits. Suppose a hedge fund called HedgeCo has an AUM of $2B as of the beginning of this year, and generated $300M year-to-date. The current AUM is now $2.3B, including the gains the fund has made to date. Before distributing the gains to investors, the fund takes a 2% fee from the total AUM, equalling $46M (or $2,300,000,000 x 0.02) in addition to a 20% fee from its capital gains, equalling $60M (or $300,000,000 x 0.20).
Investors have become increasingly concerned over this fee structure. The primary issue surrounding this is that these fees are not entirely favorable for investors, and investors are currently advocating for this distribution to be shifted in favor of the investors a bit more in the future.