Are Fund of Funds Worth It?

Hedge funds spend endless time and money strategizing and actively managing portfolios to get the highest return for their investors, who in turn pay them a 2% management and 20% performance fee. Hedge fund of funds spend even more resources on top of that on manager selection and other things. But is all their effort really worth it? Perhaps not. Back in 2008 Warren Buffet made a bet with Ted Seides and Jeffrey Tarrant of Protégé Partners LLC, a fund of hedge funds. He bet that funds that invest in hedge funds couldn’t beat the stock market over 10 years. The Protégé co-founders took him on and made an index of five hedge fund of funds to put up against Vanguard’s low-cost Admiral mutual fund, which tracks the S&P 500. For those of us looking to start investing our own money into these kinds of funds within the next 5-10 years, this may be a worthwhile bet to follow until its conclusion on December 31st, 2017.

Protégé’s reasoning was that hedge funds’ ability to hold securities both long and short, and hence bet on both rising and falling prices enabled it to outperform the S&P even after fees. On the other hand, Buffett argued that while “a number of smart people are involved in running hedge funds…their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors.” In addition to the regular 2% management fee and 20% performance fee, fund of funds charge an average extra 1.25% and 7.5%, while Vanguard’s fund charges a mere 0.07%.

Buffett may have drastically 'lost' the bet in year 1 when stock markets crashed in 2008, but he has 'won' years 2, 3 and now 4, as Admiral shares returned 2.2% versus Protégé's -4.5%. It is now almost fully caught up with Protégé, who is down a cumulative 5.89% since the start of the bet, while Admiral is close behind at -6.27%. However, with both funds fighting a close battle, it is hard to say who will be proven right in six years when the bet is over. The only sure winners are the chosen charities that will be receiving a hefty $1 million from the eventual loser of the bet.

Vivien Sung