Why Top Hedge Funds Can't Outperform the Market

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Hedge funds are known as the "smart money" on Wall Street, and in the past, that distinction was justified.

For years, hedge funds successfully managed risk and made well-placed bets, leaving their investors with a return they were happy to pay for.

But recently, hedge funds have underperformed the market, earning a return of just 7.32% in 2012, according to research firm eVestment, compared with last year's S&P 500 return of 13.41%.

Was 2012 just an outlier, or are hedge funds really inferior to a market-based index?

One investing legend thinks it's the latter and has even gambled $1 million on it.

Warren Buffett's $1 Million Bet Against Top Hedge Funds

Warren Buffett, CEO of Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), made a $1 million bet with money-management firm Protégé Partners in 2008 that top hedge funds couldn't outperform the market over 10 years.

To represent his side, Buffett chose an S&P 500 index fund run by Vanguard, and Protégé chose five funds managed by top hedge funds.

Both sides had steep losses in 2008, the first year the bet was placed. Buffett's index lost 37% that year and the five funds picked by Protégé lost on average 24%.

Now five years later, each side has clawed its way back, and for the first time ever, both sides are in positive territory.

At the halfway point of the bet, the index fund is up 8.69%, while the hedge funds, taking into account fees and expenses, are on average up only 0.13%.

So far Buffett looks right, and he's not the only money manager telling investors to avoid hedge funds.

Soros' Take on Hedge Funds

Speaking from the World Economic Forum in Davos, Switzerland, George Soros says hedge funds fees eat into profits - a lot.

Hedge funds are like mutual funds for the rich - investors must meet an annual salary requirement and have at least $1 million in net worth to invest in the funds - and they come with high fees.

Normally, hedge funds collect 20% of any gains they make, plus a 2% management fee on all assets invested.

The fees mean hedge funds generally must perform much better to beat the return of an index fund like Vanguard's, which has total fees and expenses of just 0.17%.

Soros says other problems limiting hedge funds' returns are their increased influence on the markets and the fact that investors are taking on less risk.

"Since hedge funds are now a dominant force in the market, they can't, as a group, outperform the market," Soros told Bloomberg News. "Outperforming the market with low volatility on a consistent basis is an impossibility. I outperformed the market for 30-odd years, but not with low volatility."

And as hedge funds become larger and comprise more of the daily trading volume, they lose part of the advantage that covering your bets, or hedging, is supposed to do.

"Back when I got into the industry, the word 'hedge' actually meant a hedge," former investment banker Carol Roth told Yahoo! Finance. "If you're churning the funds over and over again, you probably won't outperform the market over a long period of time."

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