Ask Stacy: What the Heck Is a Hedge Fund and How Do They Work?

Here's what they are and why they may be the dumbest thing you can do with a million bucks.

This isn’t how the rich get richer

In 2008, investing legend Warren Buffett made a bet with a hedge fund called Protégé Partners. The bet was for $1 million, and the rules were simple: If Protégé could beat the Vanguard 500 Index Fund over 10 years, Buffett would contribute $1 million to a charity of its choice. If not, it would contribute a like amount to the charity of Buffett’s choice. The bet started Jan. 1, 2008.

This should have been a cakewalk for Protégé. The Vanguard fund is completely unmanaged. It’s simply a basket of stocks designed to track the returns of the stocks of 500 large American companies. Hedge funds, on the other hand, are not only staffed by Wall Street’s best and brightest, they’re much more flexible. As I explained, they can invest in anything from complex derivatives to single-family homes. They can bet against the market and profit when stocks fall. They can use futures and options.

This should have been like betting on a 5-year-old in a fight with a professional boxer.

In this case, however, the boxer is so weighed down by fees that he can’t move. As of April 2016 (the most current data I could find) here is how the competition stands, according to Fortune:

The fund Buffett picked, Vanguard 500 Index Fund Admiral Shares (which invests in the S&P index) is up 65.67%; Protégé’s funds of funds — funds that own a portfolio of positions in a range of hedge funds— are up, on average, a paltry 21.87%.

The bet will formally end on Dec. 31 of this year.

What can we learn from this?

Hedge funds, at least taken as a whole, represent what could be one of history’s silliest examples of paying more to get less. If paying twice the price for a shirt because of a designer label is dumb, what should we call paying a manager $40,000 to radically underperform an unmanaged index?

Granted, there are hedge funds that trounce the S&P 500 and are well worth whatever outrageous fees their managers charge. But finding one would be like looking for a needle in a haystack.

Hedge funds are useful, however, when it comes to learning about all kinds of investing. Here’s what I think those lessons are:

  • It’s hard to beat the market. There are so many unpredictable variables affecting things like stocks that few people can consistently outperform the market, no matter how smart they are or what they charge.
  • You don’t always get what you pay for. Hedge funds not only charge ridiculous fees, you have to be rich before they’ll even take your money. Presumably, people who can meet million-dollar minimums aren’t stupid. But if they’re not, why are they paying so much and getting so little?
  • All hat, no cattle. Those in the business of selling their “expertise” want you to believe markets are far too complex to navigate without paying them — handsomely. Warren Buffett knows better. And now, so do you.

So, what do you think? Is Wall Street advice worth the money, or is it all just smoke and mirrors? Sound off below or on our Facebook page.

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You can ask a question simply by hitting “reply” to our email newsletter. If you’re not subscribed, fix that right now by clicking here. The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.

About me

I founded Money Talks News in 1991. I’m a CPA, and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. If you’ve got some time to kill, you can learn more about me here.

Got more money questions? Browse lots more Ask Stacy answers here.

Stacy Johnson
Stacy Johnson @moneytalksnews
I'm the founder of Money Talks News and have spent the last 40+ years in the personal finance trenches. I'm a CPA, author of a few books and multiple Emmy recipient. I'm ... More

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