Active vs. passive fund management

The current issue of Fortune is its investor's/retirement issue, and has several good stories. The obligatory Buffett story is particularly good this time, as it covers a bet between Buffett and a hedge fund as to whether the hedge fund can beat the S&P 500 over 10 years. The basics are:

Protégé has placed its bet on five funds of hedge funds - specifically, the averaged returns that those vehicles deliver net of all fees, costs, and expenses.

On the other side, Buffett, who has long argued that the fees that such "helpers" as hedge funds and funds of funds command are onerous and to be avoided has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protégé has selected.

Will 2 and 20 doom Protégé to lose?

The hedge fund selections have a big obstacle to overcome, fees:

A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones "bought" by Buffett in the bet.

On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the "helpers" that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

The summation is pretty obvious. For Protégé to win this bet, the five funds of funds it has picked must do much, much better than the S&P.

Personally, I think that individuals can beat the market over an extended period of time (I hear the Bogleheads screaming at me already). However, I don't think that typical hedge fund performance justifies anywhere near their typical fees. In losing years, the hedge funds are still taking their standard 2% management fee, to which I say, thanks for nothing.

Long Bets

Don't miss the part of the story that describes the long bet mechanism that made this bet possible in the first place. It's a cool innovation.