How to lose a $1million bet (and also how to compare apples and oranges)

Ted Seides, CIO of Protege Partners, explains why he’s losing his bet against Warren Buffett. The bet, for $1million, was over which would outperform over 10 years – an S&P500 index fund (Buffett’s choice) or a fund of hedge funds (i.e., what Protege Partners does).

Now I want to point out, at the outset, that the terms of this are goofy. While the popular press seems to think that hedge funds are intended to trounce the market, they are, generally, not. They are intended to *diversify* a portfolio, and hopefully, have good /risk-adjusted/ returns. Hence the word “hedge” in their name. Of course, they rarely do that, and a huge part of that is because of their absurd fee structure. And many of them, in perfectly rational response to incentives (i.e., they get big paydays if they trounce markets) — ignore the “hedge” and low-volatility ideal and just make aggressive bets.

 

That said, they were willing to take the bet. And they are losing big.

But one of the points that Ted makes in his explanation is that the S&P500 is not a good benchmark, and that the hedge fund has generally only had about 60% “market exposure” – i.e., it’s got a lower volatility.

So taking that comment to heart: The hedge fund is up a cumulative 19% over the last 7 years, after fees (which ate another 19% or more).  And was down only 24% in 2008.

The S&P 500 fund (VFIAX) is up 63% over those 7 years. But with a lot more volatility and having suffered a 37% loss in the first year.

So what happened to a *balanced* fund? Well, Vanguard’s got one. VBAIX is about 60% stock and 40% bonds. It’s up 60% over those 7 years – almost the same as the S&P 500. With barely more than half the volatility, and in 2008, was down only 22% rather than the 37% that the S&P500 lost. Note again that in 2008 the hedge funds were down — guess what — 24%.

We don’t have individual year-by-year returns for the hedge funds handy, and it would be interesting to compare — but it sure doesn’t look like the hedge funds returns demonstrated any less risk than a moderate balanced portfolio — yet still underperformed them by a huge margin.

Note that none of this is intended in any way as investment advice.  Asset allocation decisions, risk tolerance, tax issues — it’s a lot more complicated than simply saying “this is better” or “that is better”.

Here’s Ted’s piece wherein he tries to explain why he’s losing the bet:  <http://cfainstitute.tumblr.com/post/110804139197/betting-with-buffett-seven-lean-years-later>

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