Why Hedge Funds Are Embracing Warren Buffett’s Classic Advice About Index Funds
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To the average person, a hedge fund manager is perhaps the first image that comes to mind when thinking of a quintessential Wall Street character: a suited guru shouting orders into the phone, brokering trades that make their clientele rich. But recently, reality paints a different picture. After a subpar year in 2023, portfolio managers have been forced to shift strategies, with many turning to vanilla index funds to make up for poor performance.
Last year was a bounce back for the broader market after a dismal 2022, but it was still not kind to hedge fund investors, who expect their money managers to produce returns that beat the market averages. According to recent survey data from banking company BNP Paribas, hedge funds saw a return of 6.67% globally throughout 2023, 1.5% shy of their intended target rate. Comparatively, the S&P 500 produced a 24% return last year, allowing investors who embraced the simple strategy of investing in index funds to experience similar gains.
As a result, many of those hedge funds are altering their approaches and investing in index funds, which are being driven by the ongoing success of large cap stocks. The trend exemplifies why many retail investors heed the long-touted adage of Warren Buffett: Index funds are the best way for an investor to get stock market exposure. Hedge funds, it appears, are taking notice, too.
It might not seem shocking that a portfolio manager turns to an investment that makes money — that's their job. But hedge funds don't typically dip into index funds. With their high fees, and thus high net worth investors, these funds are typically involved in more complicated strategies meant to beat the index funds that they're now buying. This emerging reliance on index investing is a clear sign that hedge funds are grasping for a life preserver.
Hedge funds are investing like index funds
Regardless of the state of the market, the primary goal of a hedge fund is to deliver positive returns to their typically high-net-worth clients. However, in 2023, those returns fell well short of what investors and fund managers hoped for, even as the major indices rebounded from 2022's bear market.
Some of the world’s largest and most reputable hedge funds, like Citadel’s Wellington fund or the Sculptor Master fund, saw returns in 2023 of 15.3% and 12.9%, respectively. While impressive compared to the aggregate, these funds sorely underperformed when compared to the S&P 500 or the tech-heavy Nasdaq-100, which returned an eye-popping 55% during the same time.
One way these hedge funds were able to rebound, though still falling short of expectations, was through “index hugging” — when an actively-managed fund (like a hedge fund) invests more like an index in order to improve its returns.
Data from Goldman Sachs’ Hedge Fund Trend Monitor reveals that hedge funds are narrowing their underperformance to index funds by shifting their portfolio weighting much more heavily toward growth stocks, such as the “Magnificent 7” tech stocks that represent the largest holdings in many index-weighted portfolios. Of the more than 700 hedge funds analyzed, nearly one in seven have Amazon, Microsoft and Meta among their 10 largest holdings.
Taking Warren Buffett's advice
Warren Buffett is well known for his opinion that the average investor should buy and continue to accumulate investments in index funds. In 2020, Buffett said that “for most people, the best thing to do is to own the S&P 500 index fund, adding “People will try to sell you other things because there's more money in it for them if they do.”
This no-frills investment strategy is one of the best for ensuring long-term, low-cost gains. However, Buffett’s advice is not necessarily meant for hedge funds but individual investors. In fact, there are multiple problems which arise from hedge funds hugging indexes for returns rather than pursuing alpha (gains in excess of market benchmarks). One of these is that many hedge funds look almost indistinguishable from one another as they crowd into the same positions. This could have huge implications if the market were to shift for the worse and those funds were to act rashly in unison.
Another issue is that investors in these hedge funds are not getting the services they are paying for. Hedge funds often require lofty service fees from their clients — typically a management fee of 2% of the fund's net asset value and a performance fee of 20% of the fund's profits in addition to a minimum investment that typically starts at $100,000 but can range north of $1 million. These payments make hedge funds less accessible for average investors, but if funds are simply buying and holding what index funds are holding, then the people invested in them are paying far more for something that still underperforms the very indices they are trying to imitate.
Whether hedge funds will be able to meet their overperformance expectations for 2024 will be a matter of paring down on mega-cap investments and pivoting toward more dynamic strategies. But the big takeaway for the everyday investor is that Buffett’s advice still rings true in 2024; index funds provide one of the cheapest and most proven ways to invest for long-term growth. Even the fancy hedge fund managers on Wall Street are embracing this concept, though they may be quiet about it.
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