Just when we might be thinking that really wealthy people have great investment opportunities not available to the rest of us, the facts suggest otherwise. Warren Buffett, for example, appears to be winning his $1 million bet that no hedge fund, after its excessive fees, can outperform the S&P 500 index over a 10-year period.
According to a recent Fortune magazine article, Buffett appears to be winning that bet even after giving the hedge funds a head start. The gift to the hedge funds was the first year when the market was imploding. In theory, hedge funds make money (or at least lose less) when markets are in a death spiral. Even with that advantage, six years into a contest that began on Jan. 1, 2008, the hedge fund is up only 12.5 percent while the 500 index is up 48 percent.
So why would an intelligent person agree to pay a typical hedge fund 2 percent per year regardless of results -- plus an additional 20 percent of whatever profits they generate? An increasing number of articles in the financial press point to the fact that college endowments and pension funds keep investing increasing amounts of money in so-called alternative investments with dismal results.
The Wall Street Journal cited a poll of college endowments totaling $450 billion. Of that amount, 53 percent of the money was now in alternative strategies, up from 33 percent in 2003. The same article pointed out that while the S&P 500 was up 137 percent since early 2009, the average hedge fund gained 48 percent. Other alternative investments such as venture capital funds earned 81 percent and private equity funds earned 109 percent.
In other words, all of the alternative smart-money opportunities have badly lagged the tried and true index investment available to all of us at an annual cost of just 1/20th of 1 percent in fees -- essentially free money management.
Going one step further begs the question of whether or not a 500 index fund investing in a broad cross section of the 500 largest U.S. companies is really a meaningful standard of comparison.
What we know is that this fund in the year ending December 2010 earned exactly 0 percent per year as an average annual return for the preceding 10 years. It was the "lost decade" for the S&P 500. At the same time, however, a mix of several fund types, including a small company fund, a mid-sized index fund, a Real Estate Investment Trust fund and an international fund earned a combined return of roughly 6 percent per year over the same 10-year period. Not such a lost decade after all for those who took the trouble to adopt some moderate diversification.
As of June 2014, the same mix of funds has actually earned an average annual return of about 10 percent over the past 10 years while the S&P 500 clocks in at 7.75 percent. The problem with using the 500 index as a benchmark is that it does not represent an even dispersion of money across corporate America. Instead, it can be skewed by single industries that do really well and then flounder. Financial services at their high point in 2007 represented almost 40 percent of the entire value of the 500 index. When that industry imploded, it took the index with it. Now, technology has become the elephant in the room with a 20 percent share of the total value.
For the small investor still intent on building asset size with reasonable certainty and less risk, a mix of funds as described above can lead to less risk and more predictable results. Buffett selected the 500 index as his challenge to beat only because he didn't want to have to think about it much and wanted to humiliate his opponents by choosing the simplest investment available. For the rest of us, a little more thought and diversification will go further in beating that smart money in investment products that the buyers don't understand.