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Written by: Steven Brod | Crystal Capital Partners
In 2008, Warren Buffett famously challenged the investing community, betting that an S&P 500 index fund would outperform a selection of hedge funds over ten years.1 His bet was against Ted Seides, a prominent hedge fund manager and co-founder of Protégé Partners.
Buffett won, which led many to scrutinize and mischaracterize hedge fund performance. As we are just over halfway through 2024, it is interesting to see if Buffett's challenge still holds. The HFRI Fund Weighted Composite Index is up 5.01% year-to-date through June 2024,2 compared to the S&P 500's 14.48% increase.3 However, this comparison does not tell the full story.
Not all returns are created equal. Advisors who simply contrast hedge fund returns with the oftentimes double-digit performance figures of the most popular index funds or exchange-traded funds (ETFs) are missing the mark. It is paramount that advisors look under the hood of performance metrics before advising clients on portfolio allocations.
Hedge funds employ actively managed, oftentimes, absolute return strategies, aiming to generate positive returns regardless of market conditions. Their primary aim is to generate alpha through manager skill, which differentiates them from passive products like most ETFs (although active ETFs are increasing their market share), which for the most part only provide market beta exposure.
To correctly analyze hedge fund performance, advisors should familiarize themselves with the term risk-adjusted return (RAR), which adjusts returns for the level of risk taken. Key metrics involved in this include the Sharpe Ratio, which measures the return per unit of risk using the standard deviation of a particular return stream, and the Sortino Ratio, which focuses on downside risk – ratios above one for both are good, and above two are excellent. Alpha, which looks at excess returns relative to a benchmark, is also a key metric to identify whether manager skill and not market beta is contributing to a fund’s performance. Hedge funds use RAR to make informed decisions based on an investment’s ‘true’ performance.
By contrast, ETFs use total return and tracking error metrics. Total return measures how much an investment has grown over time, expressed as a percentage of the amount invested, including income and capital appreciation. It is used as a representation of the actual rate of return of an investment. Tracking error is the difference between the returns of the index fund and the target index the ETF is tracking. This metric is crucial for ETF performance assessment, as it indicates how consistently close the fund’s performance is relative to its benchmark.
The differing metrics used make sense once you understand the different investment philosophies and risk-return profiles of the products. Hedge fund strategies involve higher complexity and risk, often employing leverage, shorting and derivatives, and therefore risk-adjusted return metrics are crucial to provide a more comprehensive performance evaluation. Hedge funds should also exhibit a low correlation to equity markets, so that they can effectively hedge a portfolio. By comparison, index tracking is simpler and more predictable, and so total return figures suffice for performance analysis.
A hypothetical case study can illustrate the importance of distinguishing between these metrics. Imagine a hedge fund with a market-neutral strategy that achieved an average annual return of 6% over three years, while an ETF tracking the S&P 500 posted a higher average return of 6.67%. Despite this, the hedge fund had significantly lower volatility (3% vs. the ETF's 10%), resulting in a superior Sharpe ratio (1.33 vs. 0.467). This example demonstrates two important concepts: that while the ETF had higher raw returns, the hedge fund offered better risk-adjusted returns; and that considering volatility and risk in investment performance evaluation is crucial to accurate assessment.
Another illustrative example is provided by a comparison of hedge fund indices and broad equity indices during significant market sell-offs. Data shows that hedge funds, represented by various indices, have generally mitigated losses compared to broader equity indices like the S&P 500, Nasdaq Composite and MSCI World Index during market downturns. For instance, during the market sell-off from November 07 to February 09, hedge funds experienced smaller declines (Barclay Global Macro Index at -2.33%, Barclay Equity Hedge Index at -14.24%) compared to the Nasdaq Composite Index's -51.80% and the S&P 500's -50.95%. This highlights the drawdown protection and portfolio diversification hedge funds can offer.4
Given the nuances in performance evaluation, there are several practical considerations that financial advisors should keep in mind when implementing either traditional or hedge fund strategies into a client’s portfolio. First, as part of best practice, advisors should be able to explain risk-adjusted return metrics to clients and make sure that clients are not simply constructing a portfolio of funds based solely on their total returns. Second, advisors should carefully choose appropriate investment vehicles based on client risk tolerance and goals. Third, in choosing these vehicles, advisors should be mindful to balance hedge funds and ETFs in portfolios to ensure effective risk management and performance optimization.
Financial advisors play a crucial role in determining the best investment strategies for their clients. Advisors must compare different risk metrics when creating a portfolio, rather than simply opting for high-return investments without considering their risk and volatility profiles. Not all returns are created equal, and when looking to preserve and enhance a client’s wealth over a given time period, the highest performing strategy may not always be the most appropriate.
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- Floyd, David. Investopedia, Jun. 2019. https://www.investopedia.com/articles/investing/030916/buffetts-bet-hedge-funds-year-eight-brka-brkb.asp
- HFR. https://www.hfr.com/indices/
- S&P 500. https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview
- Crystal Research