Hedge Fund Vs. Index Fund: A Comparison

Hedge fund investing promises a very simple outcome: Give your money to a manager and he or she will do whatever it takes to make your assets rise in all markets.

Stocks down? Covered. Bond crash? Covered. Neither? No problem. Hedge fund managers attempt to do this by being very active with your money. The general theme is to use leverage to ensure that extreme outcomes don’t sink the ship while asset picking provides a solid gain, what the marketing departments of such firms call “absolute” return.

So goes the pitch. It’s more illuminating, however, to consider how they operate legally, rather than what a hedge fund does or doesn’t buy.

Goodbye prudence

First of all, forget completely about basic “prudent investor” rules. The point of hedge fund management is to take risks. For that reason, hedge funds above a certain size in the United States are regulated by the Securities and Exchange Commission, unless they work with accredited investors, that is, wealthy people who in theory understand investment risk.

Second, hedge funds operate under what’s known as the “2 and 20” format. That is, it cost 2% of your assets per year to be in the fund, and the managers keep 20% of any profits. (Obviously, any losses are 100% yours.)

Let’s do some quick math on the cost, then. If you had, say, $1 million to invest, then your annual cost of just placing the money is $20,000. If the fund posts a 10% gain, you don’t get $100,000. Instead, you get $80,000 and the managers keep $20,000.

Then the fee comes out. The “split” comes to a net $60,000 for you and $40,000 for the managers. Nice work if you can get it.

Risk-managed return

Consider a portfolio of index funds or ETFs. There’s no promise of absolute anything. However, a thoughtful collection of index funds will provide a balanced, risk-managed return similar to what you’ll find under the hood at a university endowment or corporate pension fund.

The cost of a typical collection of, say, ETFs, might average 0.2%. By rebalancing these funds over time, you realize the power of prudent management and take advantage of distortions in the market, sometimes caused by the galloping elephants we know as hedge funds.

That $1 million is now being managed for just $2,000. There is no fat 20% deduction on gains. At the end of the year, a 10% increase means $98,000 to you, compared to just $60,000 in a hedge fund. The extra cash then grows by compounding for you, not them.

Buffett’s bet

Warren Buffett, the billionaire investor, made a bet five years ago in Fortune that an S&P index fund over 10 years would beat a selection of hedge funds picked by a New York money manager. Five years have passed, including the declines of 2008 and 2009, a time when one might expect hedge fund strategies to reign supreme.

The score? Hedge funds 0.13% and index funds 8.69%.