Absolute Return  

Buffett’s £1m bet exposes hedge funds' shortcomings

Charles Younes

Charles Younes

The debate around hedge fund performance and excessive fees resurfaced recently after Warren Buffett won his bet with Protégé Partners, a specialised asset management firm that invests primarily in small hedge funds. 

In 2008, Mr Buffett issued a challenge to the hedge fund industry, which in his view charged exorbitant fees that the funds’ performances couldn’t justify. His ultimately successful contention was that, including fees  and expenses, an S&P 500 index fund would outperform a hand-picked portfolio of hedge funds over 10 years. 

Protégé Partners accepted, and the two parties placed a £1m bet. The firm’s co-founder conceded defeat ahead of the contest’s scheduled wrap-up on December 31 2017, saying: “For all intents and purposes, the game is over. I lost.”

Nevertheless, there is still room for hope for the hedge fund industry. Most UK investors can access absolute return strategies through funds located in the Investment Association’s Targeted Absolute Return sector, which has averaged a year-to-date performance of 2.9 per cent. This figure hides a diversity in performance between products, as hedge fund managers have complete freedom in their investment strategies and stockpicking.

Long/short equity managers have achieved double-digit returns this year. In addition to the positive direction of global equity markets, they benefited from a friendlier environment for stockpickers. This was highlighted by the decline in correlation between stock prices for firms in the same industry group, as well as higher divergence in performance between sectors. Nevertheless, a few long/short managers were punished for positioning their portfolio towards a sharp fall in equity markets (negative exposure) as rich valuations might have suggested.

The overall direction of bond markets has been positive this year, despite the interest rate hikes by the US Federal Reserve, as well as data pointing to higher inflation. Fixed income arbitrageurs, who focus on inefficiencies in the pricing of bonds, did well this year too, though they are limited in their sensitivity to interest rate levels. They also benefited from further dispersion in performance between bond prices, as well as a few strong-performing sectors such as emerging market debt. This means they had to get the currency positioning right, which proved to be harder than expected with the decline of the US dollar and the surprising performance of sterling this year. 

These unexpected movements partially explain the disappointing performance of global macro managers. We had great expectations for these strategies at the beginning of 2017 as global macro products are supposed to perform strongly when differences in economic cycles arise between regions. While the US and the UK appear to be reaching the latter part of their business cycles, it looks like Europe and emerging market economies are getting closer to full speed. It was once again disappointing to observe that most global macro products – including SLI Gars and Invesco Perpetual Global Targeted Returns – posted flat performance.

Relative to traditional asset classes, the performance of hedge funds might look disappointing. Nevertheless, it also means that investors are capable of forecasting positive returns for those traditional asset classes despite rich valuations.