Week 46 - What is a Hedge Fund?

Situation: If you have a pension plan at work, the plan’s administrators are probably allocating 10% or more of your contribution to hedge funds. Most hedge funds don’t come cheap. Charges typically consist of an annual fee of 2% plus 20% of returns from any outperformance over the S&P 500 Index in a 3-4 yr period. Hedge funds purport to secure a long-term gain that beats the returns of the S&P 500 Index, with reinvested dividends. Hedge funds also try to incur less risk of short-term loss during “bear markets.” You may recall from our previous blog about hedges (Week 37) that Merriam-Webster’s Collegiate Dictionary (11th ed.) defines a “hedge” as balancing a risk, specifically “to protect oneself from losing or failing by a counterbalancing action.” In other words, if the risk of a 20% or greater loss in the S&P 500 Index were to be fully hedged, the total return for the hedged portfolio during that bear market would be 0%. In reality, almost all of the leading hedge funds lost at least 10% during the 2007-09 bear market. Today’s goal is to determine exactly how much the best hedge funds lost so that we understand what such an investment entails. 

Recently, Warren Buffett found the answer by betting against the whole idea of a hedge fund. He states that the high expense of investing in a hedge fund means it can’t beat an investment in a no-load S&P 500 Index fund like VFIAX (Vanguard Admiral S&P 500 Fund). He placed a bet to that effect with Ted Seides, of Protege Partners LLC, which markets one of the biggest hedge funds. Mr. Seides picked 5 different hedge funds to determine an average for the best performance the hedge fund industry can offer. The bet runs for 10 yrs, from 2008-17, and the winner receives a $1,000,000 zero-coupon 10-yr US Treasury Note for his favorite charity. To date, the 5 hedge funds are down 5.9% but VFIAX is also down, at -6.3% (read this link). Warren Buffett made this information available at Berkshire Hathaway Corporation’s annual meeting on May 5th. He noted that VFIAX beat the hedge funds in each of the last 3 yrs but is still behind overall because of its greater loss (36% vs. 23%) during 2008. That means the 5 best hedge funds went down only 64% as far (23/36 = 0.64) as VFIAX during the bear market year of 2008. See this link for additional information.

Over the worst 18-months of that bear market (10/07 - 4/09), VFIAX fell 45%. Now that we know the 5 best hedge funds fell only 64% as far as VFIAX during 2008, i.e., the middle 12 months of that 18-month bear market, we can multiply that 45% value (for the 18-month VFIAX loss) by 0.64, which equals 29%. Any mutual fund that returned more than VFIAX over the past 10 years, AND fell by less than 29% during the 18-month bear market would qualify to be called a hedge fund by this definition. 29% is a serious loss that most investors won’t accept. In other words, people take the “hedge” term literally. A well-designed hedge means there would be 0% loss during a bear market. 

Here at ITR, we believe you’ll do better than VFIAX and most hedge funds over 10 yrs by using DRIPs of value stocks selected from our Master List (Week 39), combined with dollar-cost averaging and dividend re-investment. You probably can’t afford a DRIP for each of the 31 Master List stocks but you can have one for each of the 12 stocks in our Growing Perpetuity Index (see Week 4, Week 21 & Week 32). Those 12 stocks have returned an average of 9.5%/yr since 7/02 and lost only 22% in the 18-month bear market. Seven stocks in the Growing Perpetuity Index actually fulfill the definition above of a modern-day hedge fund: MCD, IBM, NEE, CVX, XOM, PG, KO. Those 7 gained 10.8%/yr and lost only 23% in the bear market (MCD lost only 3%). If you had DRIPs for all 7 stocks, with an equal amount invested each quarter in ISBs (inflation-protected Savings Bonds), your total return since 7/02 for that 50:50 stock:bond investment would have been 8.0% and you’d have incurred a bear market loss of only 10% along the way. 

Bottom Line: Save yourself the fees and build your own hedge fund.


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