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MORGAN HOUSEL, author of The Psychology of Money, once made this observation: “Before the 1700s, the richest members of society had among the shortest lives—meaningfully below that of the overall population.”
It was counterintuitive, but Housel cited a hypothesis, developed by historian T.H. Hollingsworth, to make sense of it: “The best explanation is that the rich were the only ones who could afford all the quack medicines and sham doctors who peddled hope but increased your odds of being poisoned.”
Housel then added this thought: “I would bet good money the same happens today with investing advice.” Wealthy folks, in other words, are lured into “fancy” investments like hedge funds that, in Housel’s view, don’t serve investors well.
The performance of hedge funds is perhaps best illustrated by a bet made in 2007 between Warren Buffett and a hedge fund manager named Ted Seides: Buffett bet that, over 10 years, a simple index fund tracking the S&P 500 could outperform any hedge fund or group of hedge funds. For his side of the bet, Seides chose five funds-of-funds. These are funds that invest in a diversified group of other funds.
The hedge funds ended up trailing in nine of the 10 years. Seides threw in the towel before the 10-year mark, writing that, “For all intents and purposes, the bet is over.”
In his 2017 annual letter, Buffett summarized the results: Over the 10 years, the S&P 500 returned an average 8.5% a year. By contrast, the group of hedge funds returned just 3% annually.
These numbers pose a conundrum since many university endowments are perceived to have done well with hedge funds, private equity and other private fund vehicles. If they work for endowments, why don’t these same investments work for everyone else?
The late David Swensen, who for 36 years was the manager of Yale University’s endowment, provides the best explanation. When Swensen joined Yale in 1985, the endowment was invested traditionally—mostly in stocks and bonds. But over time, Swensen developed a new strategy, one that leaned heavily on hedge funds and other private vehicles. This new strategy delivered strong returns, and in 2000 Swensen wrote a book titled Pioneering Portfolio Management, which was a sort of cookbook for other fund managers who wanted to do the same thing.
A few years later, Swensen wrote a second book, titled Unconventional Success, with the goal of providing individual investors a formula for applying the ideas he’d developed at Yale. The project took an unexpected turn, though. As Swensen began looking at the numbers, he realized that the private fund strategy he’d developed for endowments wouldn’t work for individuals, for a number of reasons.
First is access. Owing to their partnership structure, hedge funds are limited to just 500 investors. Because of that cap, they have to be selective. It makes sense that, for those limited slots, they’d choose the investors who could write the largest checks. And while all funds face this same constraint, the funds that can be the most selective are the ones with the best performance. Result? As a rule, only funds with lower-tier performance are open to individual investors.
This problem is compounded by the fact that there’s a wide gap between the best and worst funds in the world of private investments. According to a study by consulting firm McKinsey, the difference between the best and worst among private funds is much greater than the difference among publicly available investments like mutual funds and exchange-traded funds (ETFs).
Fees are another issue. To appreciate the impact of private fund fees, we can compare the fees on a typical S&P 500 index fund to those imposed by the average hedge fund.
Vanguard Group’s S&P 500 fund charges a management fee of 0.03% a year and no performance fee. Over the 10-year period of the Buffett-Seides bet, what would an investor have paid to a hedge fund?
Private funds charge investors two separate fees, known as “2 and 20.” The first component is the management fee, which is usually 2% of assets under management. On top of that, most hedge funds collect 20% of the profits, known as the performance fee. During the 10-year period of the bet, the S&P 500 returned 8.5% a year, so the performance fee would have added another 1.7% (20% x 8.5%) to the annual cost, for a total of 3.7%. The hedge funds, in other words, would have charged 120 times more than the index fund (3.7% vs. 0.03%) to manage the same set of investments.
This was a key reason Buffett felt confident in betting against hedge funds. “Performance comes, performance goes. Fees never falter,” Buffett wrote. In reflecting on the results, Seides didn’t disagree on this point: “[Buffett] is correct that hedge-fund fees are high, and his reasoning is convincing. Fees matter in investing, no doubt about it,” Seides wrote.
Taxes are another key consideration with hedge funds. While they pursue diverse strategies, hedge funds are usually all trying to beat the market. As a result, what they have in common is that they trade frequently, and that almost always translates to tax-inefficiency.
Taxes generated by hedge funds also tend to be unpredictable, varying in relation to the fund’s trading results each year. For high-net-worth investors, who are most vulnerable to higher tax brackets, hedge funds tend to make tax planning an uphill battle.
If hedge funds weren’t a good fit for individual investors, what did David Swensen recommend? “Instead of pursuing ephemeral promises of market-beating strategies, individuals benefit from adopting the ironclad reality of market-mimicking portfolios….” In other words, index funds.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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University endowments also have the benefit of an unlimited time horizon. I I believe that there was a study that indicated most endowments would have been better off with indexing and a low fee, vs. the roulette wheel of managed investments plus the associated fees.
Another issue, but it makes me wonder – for the few universities with huge endowments – what is the ultimate purpose of an every growing endowment? They seem obsessed with obtaining ever more donations, to what end??? Without taking any risk they could fund current and future needs. Even provide free or much reduced tuition, but continue to raise tuition in lockstep with their peers.
it is the down years that are the ‘downfall’ of managed money..in the up years the difference between 10% and 8% are ignored ..everyone’s getting fat and healthy!
you are healthier than me with your higher returns but we’re all making cheddar. but a few years of down 10% and than paying fees of 2%+ you get poorer faster; that stings.
there is a reason animals travel in a herd…the safety of the crowd..the front is in more danger but have some rewards of first pick of resources, the hindmost eaten by predators..easy pickins’, but the middle just trudges on going from place to place relatively safely.
it is about minimizing the effects of the lean times if you’re in for a long hall..risk/reward is the game and a hot tip, a gut feeling, a sense that one is smarter when all are similar in the game is the real risk and paying 2% year in year out for the aforementioned ideations is a choice that might not pay off…spoiler..they’re not all berkshire hathaway.
past performance and future earnings, blah-blah verbiage is there for a reason..not advice, disclaimers. as they say every time they open the door to the casinos ‘good luck!’.
I have been pondering the following for about 3 decades. I immigrated to the US with my family with just $5K which was gone in 2 months. I didn’t know much about investment. After I read the book A Random Walk… I started to invest in 1995 in Vanguard indexes. My goal was one million dollars.
I told anybody I know that if you invest just $1000 per month at 8% annually, you will have 1.4 million since compounding is a huge force.
I got a lot more and retired after 23 years in 2018. It was all based on investing, never options or crazy raises, and we never had pensions or inheritance.
Today, $1 million is worth a lot less than 30 years ago, but the % of people who have a $1 million dollar portfolio is still small, maybe 10%.
It was one of the easiest decisions I have made in my new country.
I still ponder why many can’t do it.
Whatever the topic, there is no shortage of ratings to inform us who or what is the “best”. If the topic is sports, individual players, teams and coaches are ranked. Likewise for various automobiles, top medical or surgical specialists, the best hospitals, colleges and universities. And of course the top wealth advisors. A typical young, or not so young, worker who thinks about saving and investing for eventual retirement, will encounter the not so subtle message that they ought to aim to outperform others.
While various polls and ratings have their uses, a skeptical consumer will take the information under advisement but remain open minded. But the sports metaphor of hiring the best financial advisor to crush the competition” seems a bit absurd. The term “average” is a put down in the marketing world, where everyone ought to desire the “best”. Most readers on this site are well aware of the difference between the returns earned by average investors, and the average returns from various stock market indexes. Bogle and many others have written a lot about this. A sales person might chide an index fund investor for “settling for average”, when in fact those returns are much greater than what average investors earn, over long periods.
Great article, Adam!
Another great article. Don’t know how you and Jonathan come up with such pithy and informative articles so frequently.
It’s hard to overstate how much low-cost index funds have benefited the “little guy.” How many other big wins require such little effort?