What Is a Hedge Fund — The Pursuit of Absolute Return

A hedge fund is a fund that pursues 'absolute return.' Here, absolute return means the goal of producing a positive return regardless of whether the market rises or falls.

An ordinary fund usually measures 'did it do better than the index' against a market index. A hedge fund, by contrast, claims to aim for returns themselves, independent of direction.

To do this, it uses various strategies. A representative one is long/short. It simultaneously buys stocks likely to rise (long) and short-sells stocks likely to fall by borrowing and selling them in advance (short). On top of this, it combines leverage—borrowing to enlarge the investment size—derivatives, and arbitrage. The name 'hedge' originally means to offset risk, but in practice, it often uses strategies that magnify risk.

Hedge funds, like private equity, often use the '2 and 20' fee structure.

Each year they take about 2% of the assets under management as a management fee, and on top of that take 20% of the profit as a performance fee. That is, when the fund earns, the firm pockets one-fifth of that profit, and even when there's a loss, the 2% management fee drains out each year.

Hedge funds also often place constraints on withdrawing funds. A lock-up is a mechanism that prevents you from withdrawing money for a certain period after investing, and a gate is a device that restricts withdrawals when many investors try to pull money out at once. It means that at the very moment the market plunges and everyone wants to pull their money out, they may instead be blocked from doing so.

The promise 'we earn regardless of the market' is attractive, but in reality the results often fell short of expectations.

Especially in the 2010s bull market, the hedge fund average continuously lagged the S&P 500 index. According to one compilation, from 2011 to 2020 hedge funds trailed the S&P 500 every year, producing on average about 7.5 percentage points lower per year over the 10 years.

The years the hedge fund average beat the S&P 500 were roughly 2015, 2018, and 2022—and these were all years the market fell. In other words, when hedge funds won, it was not that they 'earned more' but that they 'lost less.'

Why did this happen? Because high fees eat into returns, and it's hard to keep guessing the market's direction right. Of course, there are a few hedge funds that produced outstanding performance over a long period, but it was not easy for the 'average hedge fund' to beat the index.

The most famous case on this topic is Warren Buffett's bet.

In 2008, Buffett wagered $1 million that 'over the next 10 years (2008–2017), a simple S&P 500 index fund would beat a bundle of high-flying hedge funds (a fund of funds).' It was on a net-return basis after deducting all fees and costs.

The result was a complete win for Buffett. Over the 10 years, the S&P 500 index fund recorded a cumulative return of about +125.8%, while the opposing bundle of five hedge funds returned 21.7%, 42.3%, 87.7%, 2.8%, and 27.0% respectively, averaging only about 36%. The gap was enormous.

Buffett donated the entire prize to charity. The lesson this bet gives is clear. Dazzling strategies and high fees do not necessarily lead to better results; on the contrary, simple index investing at low cost often came out ahead over the long term.