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Hedge Funds Could Use A Better Champion Than Buffett-Bet Loser Ted Seides

If your basic argument is “we expected stocks to do something they didn’t do,” you're doing Buffett's job for him.
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Here are some things a majority of hedge fund managers are good at:

  • Convincing people that some bet they're taking will generate alpha – otherwise known as “raising capital.”
  • Concocting excuses when some bet they took didn't generate alpha – otherwise known as “investor relations.”

Here's something a minority of hedge fund managers are good at:

  • Consistently generating alpha.

Sometimes those skill sets overlap. Often they don't. And since choosing good managers is hard, investing in hedge funds isn't a sure thing. This is the basis for the extremely-familiar-by-now 2008 bet between Warren Buffett and fund-of-funds Protégé Partners over Buffett's notion that a decade-long passive position in the S&P 500 would outperform a hand-picked group of hedge funds, net of fees.

Although the contest has another eight months to go, Protégé's Ted Seides is basically throwing in the towel. In a Bloomberg View essay entitled “Why I Lost My Bet With Warren Buffett,” he admits that “for all intents and purposes, the bet is over. I lost.” Buffett, he writes:

is correct that hedge-fund fees are high, and his reasoning is convincing. Fees matter in investing, no doubt about it. It’s just not the whole story.

So why, in Seides' mind, did he lose? The pith of the argument is this: He lost the bet because he made it. If only Buffett hadn't chosen the S&P 500, and the time frame had been something other than ten years, the hedge fund wager might have won.

This, of course, is the distillation of everything hedge fund critics have griped about since the beginning of time: Of course a different bet would have been better! That's the whole point of not making one at all, i.e., going passive.

To be fair, Seides' complaint isn't exactly an argument against hedge funds (though it might serve as an effective proviso about funds-of-funds). Instead it's an object lesson in exactly the kinds of defenses hedge fund managers and their self-appointed champions should not make. That is, unless they want to absolutely confirm hedge fund skeptics' worst suspicions.

But to really appreciate the perfect irony of Seides' essay, we have to take the six planks of his self-defense one by one.

  1. “Price matters...eventually.” The basic point: stocks were expensive then and they're still expensive now. This is unfair.

The higher the price an investor pays for an asset, the less he should expect to earn. When we made the bet in 2008, the S&P 500 traded at the high end of its historical range. Probabilities strongly suggested the S&P 500 would generate low returns in the future, which would have helped the relative performance of hedge funds.

Translation: We expected stocks to do something they didn’t do.

2. “Risk matters...eventually.” The basic point: Stock markets crash sometimes, which is bad. Hedge funds hedge, which is good.

Warren and I have written during the past two years that he will win the bet absent a market crash. Hedge funds tend to significantly outperform in bear markets, as demonstrated in 2008 and 2000-2002. These same risk-mitigating properties tempered hedge-fund returns in the rally that began in March 2009.

Translation: We expected stocks to do something they didn’t do.

We should also note that if risk were the metric, Seides should have made a different bet.

3. “A passive investment in the S&P 500 is an active bet.”

Choosing the S&P 500 as representative of the market isn’t as simple as it may appear. The S&P 500 is a strategy that is concentrated in the largest U.S.-listed stocks. Compared to more diversified, low-cost passive investments, the S&P 500 is biased toward U.S. stocks relative to global stocks and large companies relative to small ones. These two bets generated anomalously strong relative performance in this period.

Translation: We expected stocks to do something they didn’t do.

We should also note that if other stock indices were better benchmarks, Seides should have made a different bet.

4. “Be careful comparing apples and oranges.” In other words, stock indices aren't hedge funds (which was kind of the point of the bet in the first place?).

It was global diversification that hurt hedge fund returns more than fees. In fact, a low-cost index of large global companies, the MSCI All Country World Index, almost exactly matched hedge-fund returns during the same nine-year period of our bet (and international stocks actually lost money during that period.) This index isn’t a perfect benchmark for hedge funds either, but it is a lot closer to an apples-to-apples comparison than hedge funds and the S&P 500.

Translation: We expected stocks to do something they didn’t do.

Also: If the S&P isn't apples-to-apples, make a different bet.

5. “In investing and in life, we live through only one experience out of many possibilities.” Just like one hand of Texas Hold'em doesn't tell you about a player's true skill, ten years of fund-of-fund returns apparently don't tell you about a hedge fund picker's true skill. Furthermore:

The unexpected strength of the S&P 500 was a key contributor to Warren’s victory. Despite trading for a high multiple of earnings and facing an elevated level of risk, the S&P 500 performed in-line with historical averages. However unlikely that outcome may have seemed nine years ago, it is the only one that played out.

Translation…well you get the idea by now.

6. “Long-term returns only matter if we invest for the long term.” Notably, stocks fell 50 percent at the beginning of the bet. This proves…something.

My guess is that doubling down on a bet with Warren Buffett for the next 10 years would hold greater-than-even odds of victory. The S&P 500 looks overpriced and has a reasonable chance of disappointing passive investors. Hedge funds mitigate risk in bear markets, while seeking to participate in some of a bull market. Investing in hedge funds is a bet against continuing bull markets; investing in the S&P 500 is a bet on a continuing bull market.

Translation (a different one this time!): We now expect stocks to do something in the future.

Of course, for item no. 6 to work, one must ignore item no. 2, that the lack of a S&P 500 crash in recent years gave Buffett an unfair advantage because hedge funds haven't had a chance to hedge. That point doesn't stop Seides from noting that, because there was a crash in the S&P 500 – the biggest since 1987! – his strategy should be better. The niggling fact that Seides' hedge funds still underperformed over the decade – even with a once-in-a-generation slump that allowed hedge funds to shine by comparison – suggests that all Seides would have needed for his method to win out is two 50-percent corrections over the course of 10 years.

Which brings us to the greatest irony of all. Seides, who has now fully demonstrated his inability to predict equity market movements, has drafted a concession speech that serves as an implicit equity market prediction. Buffett will win, we're told, because stocks aren't going down anytime soon. To make that prognostication, Seides follows the same method that he now says stung him in the first place: extrapolating the recent past into the near future.

But what if, instead of going up in the next eight months…stocks go down?

We can't say if they will – Dealbreaker is in no position to share its quantitative analysis and proprietary market projections with the broader public. But we can promise that if U.S. equities suffer a big correction (and hedge funds manage to hedge it), we will clown on Ted Seides gleefully, mercilessly and without end. Or at least until the S&P 500 has recouped its losses.


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