Dont count hedge funds out quite yet.
Its hard not to, of course, given that many if not most of them appear to be struggling. The average hedge fund in the HFR database gained just 3.6% in the first half of this year, versus an 8.2% gain for the S&P 500. SPX, +0.20%
Nor is this years performance gap unusual. To underscore the point, Berkshire Hathaway BRK.A, -0.14% BRK.B, -0.24% chairman and billionaire investor Warren Buffett is on the verge of winning a $1 million bet he made in 2007 that the S&P 500 would beat a basket of hedge funds over the subsequent decade (through 12/31/2017).
Buffett is so far ahead, in fact, that with the benefit of hindsight it seems foolish to think the bet could have turned out any other way.
The contrarian in me suspects that Buffett would lose an identical 10-year bet placed today.
Yet it certainly could have. Indeed, the contrarian in me suspects that Buffett would lose an identical 10-year bet placed today.
Thats because the stock market currently is hugely overvalued by almost any traditional measure, as I recently detailed. It strikes me as a long shot to bet that the stock market over the next decade will perform as well in the coming decade as it did over the last one.
And when the S&P 500 struggles, hedge funds are much more likely to come out on top. Theyre called hedge funds for a reason, after all. During the 2007-2009 bear market, for example, the average hedge fund in the HFR database lost less than half as much as the S&P 500.
In large part, therefore, a bet that the S&P 500 will beat the average hedge fund over the next 10 years is a bet that the stock market will rise by more than a modest amount over that period. Thats a far different bet than Buffetts otherwise appears, since most interpreted it to be a criticism of hedge funds for their exorbitant fees and poor performance.
While its true that many funds do charge too much and have performed poorly, its important to understand that a far bigger cause of their lagging the S&P 500 over the last decade is the S&P 500s strength since the 2009 bear-market bottom.
Even if you arent worried by the stock markets apparent overvaluation, it should also give you pause that its not that unusual for the S&P 500 to lag short-term bonds over a 10-year period. In fact, according to data compiled by Jeremy Siegel of the Wharton School (and reported in his investment classic Stocks For The Long Run), the S&P 500 has lost out to a money-market fund (or equivalent) in one of every five 10-year periods since the early 1800s.
So be on your guard in coming months for those who inevitably will draw the wrong lessons from Buffetts winning his 10-year bet against hedge funds. Contrarians wouldnt be surprised if hedge f unds enter a sustained period of beating the S&P 500 at the exact time cheerleading commentators are trying to drive a stake through their hearts.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email firstname.lastname@example.org.