Warren Buffett versus the hedge funds

With three years to go, Warren Buffett is comfortably winning his charity bet that a low-cost index tracker would trounce a portfolio of hedge funds over ten years.

Returns from the S&P 500 index fund is beating a portfolio of funds assembled by hedge fund manager Protege Partners by 63.5 per cent to 19.6 per cent, according to a slide Mr Buffett presented at Berkshire Hathaway's annual meeting at the weekend.

"The hedge fund managers have done very well over that period," Mr Buffett said, noting that, on a notional $1bn portfolio, they would have made $20m in management fees "just for coming to the office. The investors in the hedge funds have paid a very big price."

So why is money still pouring into the hedge fund industry? The answer is that investors do not think of hedge funds as an alternative to stocks, but more often now as an alternative to bonds. Mr Buffett's comparison is no longer a fair one - and the consequence is that the industry's meagre returns will not improve any time soon.

The latest big name investor to tout hedge funds as an alternative to bonds is Ben Inker, co-head of asset allocation at GMO in Boston.

GMO despairs of finding value in fixed income, now that even the longest dated government bonds yield less than expected inflation in Europe, Japan and UK, and barely match inflation in the US. With yields so low and prices so high, bonds no longer fit the bill as the low-risk cushion in an investment portfolio. Conservative hedge funds are a "superior anchor" for a portfolio, Mr Inker wrote.

For an industry in something of an existential crisis after years of weak returns, this is not a particularly edifying justification for its existence: "Why buy hedge funds? Because everything else sucks."

Nonetheless, another $18bn flowed into hedge funds globally in the first quarter of 2015, according to research group HFR, taking the industry's total assets to $2.94tn. This despite investors telling surveys that hedge fund returns have missed expectations almost every year since the financial crisis.

With a few exceptions, notably Californian pension fund Calpers, which axed its allocation to hedge funds, investors have responded instead by lowering expectations.

This makes sense if they are thinking about hedge funds as an alternative to bonds, where the outlook for future returns is poor to downright scary.

The phenomenon has an interesting mirror in the retail investment space, and the rise of so-called "unconstrained" bond funds, which are being marketed as an alternative to traditional fixed income funds whose value may be dented by rising interest rates. These mutual funds give managers wide flexibility to make bets, including negative bets, across the financial markets, making them, in effect, mini-hedge funds.

The marketing pitch of the hedge fund industry urges investors to look through the current malaise and promises that absolute return strategies will come into their own when equity markets stumble and rising interest rates roil the bond market. Commercial real estate and infrastructure may be more obvious substitutes for bonds, since they typically yield cash from rents and fees, but these are illiquid assets that are much harder to access than hedge funds.

Hedge funds seem to be becoming more "bond-like". An intriguing piece from JPMorgan last week outlined the declining volatility of returns at the average hedge fund.

At 3.2 per cent, the rolling average three-year volatility of the HFRI and Credit Suisse Tremont hedge fund indices has fallen to the same level as that of the Barclays Aggregate index of the US bond market.

What might explain such a development? Certainly the increasing institutionalisation of the industry. Hedge funds cater now largely to institutional investors, such as pension funds, whose officers all have nervous trustees to answer to, and they win or lose business at the whim of consultants, who are notoriously intolerant of periods of poor performance.

And then there is the question of hedge funds as a fixed income substitute. Hedge fund managers respond to supply and demand just like everybody else. If investors are looking to them to provide the kind of conservative portfolio cushion that used to be provided by bonds, then they are likely to invest more conservatively in order to win and to keep business.

The result is that hedge funds and their investors are locked in a downward spiral of lower expectations and declining returns. Mr Buffett's bet looks safe.

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