Investing in Funds of Funds is A Dumb Idea

Warren Buffett isn’t a big fan of hedge funds. He thinks hedge funds are schemes that are designed to enrich hedge fund managers who can’t beat a passive investing strategy like investing in S&P 500 index funds. He bet $320,000 more than 3 years ago against a very smart fund of funds manager, Protégé Partners. No, we don’t think Protégé Partners are smart because they can generate enormous alpha when picking stocks or funds. They are smart because this is the best advertising you can buy for $320 K. If Warren Buffett is willing to humor us, we would like to bet another $320 K that Insider Monkey’s stock picking strategy can beat the S&P 500 index funds by at least 3 percentage points per year over the next 10 years. We believe we can beat the market –  but that’s not the point. By donating $320,000, we will be getting 100 times more value through free press coverage of our website.

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Warren Buffett’s bet is also smart. He bet against funds of hedge funds, which has nearly double the fees of an average hedge fund. We believe there are hedge funds that can generate alpha after fees, but we don’t think there are that many funds of hedge funds that can generate alpha. Moreover, hedge funds have an average beta of 0.5. This means even if they have some alpha, they may still underperform the market because they partly hedge their bets. They are less risky than index funds are but Warren Buffett’s bet ignores that risk. Over a 10 year period it is more likely that the S&P 500 index will increase in nominal terms. So, funds of hedge funds have three handicaps they have to tackle to beat passive investing: hedge fund fees, FOF fees, and their low betas.

The five FOFs picked by Protégé Partners returned -24% in 2008, 16% in 2009 and 8.5% in 2010. The average hedge fund returned -18.6% in 2008, 19% in 2009 and nearly 10.5% in 2010. We don’t need to see more returns to claim that Protégé Partners’ picks aren’t spectacular. They consistently underperformed an “average” hedge fund by an average of more than 3 percentage points per year.

Investing in funds of funds is really a dumb idea. It isn’t very difficult to find out which hedge fund managers performed better over the past 5 years. Investors can imitate the transactions of those hedge funds after they test whether doing so led to higher returns in the past. Insider Monkey will introduce a free service that does this for investors. We are following more than 250 prominent hedge funds. Investors might be able to beat the market by imitating the transactions of best hedge fund managers. They don’t have to pay any fees to hedge fund managers, and they definitely don’t have to pay an added layer of fees to the managers of funds of hedge funds. They have total control of their money, so they don’t have to worry about lock-up periods or fraud either. The main drawbacks are that they don’t have access to hedge funds’ short stock picks and there is a delay. However, it is likely that there are some hedge funds that invest for the long-term, so imitating these hedge funds with a delay won’t be a big issue. Hedge funds usually generate more alpha on the long side than on the short side. So, not knowing their short positions isn’t the end of the world either.

We think Warren Buffett is more likely to win this bet against Protégé Partners. Protégé Partners will probably lose the bet but can you name another fund of funds other than Protégé Partners?