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Why Do Smart People Keep Investing in Hedge Funds?


- By Charles Mizrahi

Hedge funds had another miserable year in 2015.

While the S&P 500 index was up 1.2%, the average hedge fund lost 3%. This was on top of several years of sub-par performance.

The S&P 500 has now outperformed its hedge fund rival for 10 straight years with the exception of 2008, when both fell sharply.

A simple-minded investment portfolio, 60% of it in stock shares and the rest in sovereign bonds, has delivered returns of more than 90% over the last decade, compared with a meager 17% after fees for hedge funds.

You would think that rational investors would come to their senses and invest in a low-cost index fund instead of paying high fees for poor performance.

But such is not the case.

Source: http://bucks.blogs.nytimes.com
Source: http://bucks.blogs.nytimes.com


Why do professional investors increase their investments in hedge funds while "alternative" investments such as low-cost index funds continue to outperform them?

In addition to charging high fees - 2% management fees and 20% of profits - hedge funds offer something that whets most investors' appetites: complexity and exclusivity.

Warren Buffett (Trades, Portfolio) attempted to address why Benjamin Graham's approach was not more widely followed. His reason: It's too simple.

Most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "Take two aspirins"?

About eight years ago, Buffett made a $1 million bet, with the winnings going to charity, against two funds of funds managers. Buffett bet that funds that invest in hedge funds for their clients would not beat the S&P 500 over 10 years.

So far Buffett is winning.

The managers assembled a portfolio of five hedge funds that they hoped would outperform the S&P 500 index. So far, halfway through the bet, Buffett is winning.

Filter out the noise

While the approach we use to select financially sound stocks trading at attractive valuations sounds simple ... it's not easy.

There are many distractions that get in the way of executing such an approach.

We first need to filter out all the noise from the markets (e.g., headlines, company press releases, economic news, etc.). Once we do that, we then focus on finding companies that are unloved and unwanted on Wall Street.

When we're selecting stocks, we have the proper temperament not to get swayed by market price action. In other words, it's easier for most investors to buy a stock that rises in value than to buy one that is falling.

The stocks we select are usually trading well off their highs and are trading lower due to an event or news. This is where most investors part company with value investors. They're able to talk about buying stocks when they are trading at their lows but can't seem to pull the trigger.

As you know, we don't use "black boxes" that contain secret algorithms to select stocks. Nor do we use complicated formulas to look at a company's balance sheet. Instead we are as transparent as a fish tank. So far our approach is working remarkably well.

While we don't know what the markets will do in the next five years, or in the next five weeks for that matter, we're confident that a value approach will continue to outperform the market over the long term.

This article first appeared on GuruFocus.