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Hedge Funds vs. Index Funds: Key Differences

January 11, 2022
6
min

Hedge funds and index funds take almost diametrically opposed approaches to investing. Hedge funds use active management strategies while index funds seek a passive approach.

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It was one of the most famous bets in Wall Street history. Legendary investor Warren Buffett in early 2008 posed a challenge to the hedge fund industry: For the next 10 years, a simple index fund tracking the stock market would outperform hedge funds. He put up $1 million for the bet, using a large, well-known fund tracking the Standard & Poor’s 500 Index, and a hedge fund manager took the other side, using five funds.

The winner, hands down: Warren Buffett and index funds. The hedge fund manager conceded in September 2017, a few months before the bet's term ended. The average annual gain for the S&P 500 fund was 8.5%, or about 125% compounded for the decade. That means $1 million invested in the index fund more than doubled to about $2.25 million. For the hedge funds—not so much. The best one averaged 6.5% a year, or about 88% compounded. The worst returned 0.3% a year, or 2.8% compounded.

The contest was about two different investing styles: active versus passive management of investors’ money.

What is a hedge fund?

A hedge fund is a pool of money collected from high net worth investors and institutions that is actively managed by a hedge fund manager. The manager buys and sells different stocks, as well as other financial instruments such as derivatives, in an effort to generate returns for fund investors. Their goal is to beat the market—to perform better than broad market averages. Hedge fund managers usually have a stake in their funds.

Hedge funds tend to produce better results when markets are volatile or declining, when they have more opportunities to profit from short selling securities or from trading assets that have low correlation—meaning their prices tend not to move in the same direction as the broader market.

It’s possible to think of each hedge fund as an experiment, with the manager trying out ideas in trading securities, derivatives, and other assets. This often entails:

  • More frequent turnover, trading long and short positions.
  • Charging a 2% management fee and a 20% cut of the profits.
  • Little disclosure about performance; investors must rely on the fund manager to keep them informed.
  • Difficulty benchmarking fund performance; comparisons to common market indexes may not be relevant, because a fund’s asset mix and strategy usually will be very different from an index.

What is an index fund?

An index fund, in contrast to a hedge fund, is a pool of money collected from big and small investors that is passively managed. Its strategy is simple: follow the moves in a designated, widely known market index. The most commonly used index is the S&P 500, composed of 500 of the largest-cap companies, which together account for almost 75% of the total US stock market. The S&P 500 thus is often cited as a proxy for the entire stock market. Their goals differ from hedge funds in the following ways:

  • They seek to match the market, not beat it.
  • Investors can easily gauge performance because the funds track widely used benchmarks. For instance, if the S&P 500 rises 0.5% on the day, the index fund will rise by almost the same amount.
  • Minimal trading activity, only what’s necessary to match any adjustments to the composition of the index—computer programs do the work of adjusting without human intervention.
  • Minimal trading means low turnover in the fund, low maintenance, and very low fees; for example, the most popular S&P 500 funds charge about 0.025%, or 25 cents per $1,000 invested.

Some index funds are available as mutual funds, and others are exchange-traded funds (ETFs).

Differences between hedge funds and index funds

There are a number of key differences between hedge funds and index funds to consider:

  • A hedge fund employs an active strategy, buying and selling as the manager sees opportunities to maximize profit and minimize risk; an index fund is a passive strategy, designed to replicate, not exceed, the performance of its index.
  • A hedge fund will invite only wealthy individuals, accredited investors, and large institutions including pension funds and college endowments, and requires a large minimum investment; an index fund is available to the general public with just a small initial investment.
  • A hedge fund is lightly regulated by the Securities and Exchange Commission; an index fund is highly regulated.
  • A hedge fund is less transparent to its investors, who may only get intermittent updates from the manager; an index fund is easy to understand, and its performance and total value are updated each day the markets are open.
  • A hedge fund has high expenses of at least a few percentage points on the assets under management; an index fund has very low expenses, usually less than 0.1%.

What is a fund of hedge funds?

A fund of hedge funds is simply a hedge fund that invests in other hedge funds, like a hedge-fund conglomerate. Instead of creating its own portfolio from scratch by buying and selling particular securities, this fund takes stakes in other funds that already have portfolios. The fund of funds creates diversification through these stakes—for example, a stake in a hedge fund focused on stocks, another stake in a hedge fund trading in government bonds, and another in a macro hedge fund that bets on macroeconomic factors such as changes in interest rates and foreign exchange.

Buffett’s contest with hedge funds actually was against five funds of funds, which in turn, according to Buffett, owned interests in more than 200 hedge funds. Buffett relished doing his review after the bet concluded, noting how the hedge fund managers brought an arsenal of “brains, adrenaline, and confidence” to the contest, yet couldn’t come close to producing the results of low-cost, low-maintenance index funds.

FAQs about hedge funds and index funds

Why would a wealthy person invest in a hedge fund and not a low-cost index fund?

Hedge-fund investors often are more focused on preserving their wealth. They have already made lots of money; now they want to protect it from big market declines. At the same time, wealthy investors can afford to take the risk of a hedge-fund strategy. A billionaire, for example, could drop $1 million into a hedge fund and not be financially crippled if the fund’s strategy fails.

How much do index funds return?

Typically, the average return on index funds will come close to the referenced index’s return. For instance, for the year-to-date as of Dec. 15, 2021, the S&P 500 had a total return of 24.6%. The Vanguard 500 Index Admiral Fund, used in Buffett’s bet, had returned 23.8% during the same period. Index funds tracking the tech-focused NASDAQ index did a few points better.

How much can hedge funds return?

The average hedge fund return and the industry’s long record of underperformance has been well-established. That’s not to say there aren’t some big winners. Renaissance Technologies’ mathematically driven Medallion Fund has averaged 66% annual returns (39% after fees) since 1988, and reportedly racked up 76% in 2020. Pershing Square Capital’s activist investing strategy focusing on a handful of undervalued companies produced a 70% return in 2020.

The bottom line

Hedge funds and index funds take almost diametrically opposed approaches to investing. Hedge funds use active management strategies to try and beat markets, though they often don’t succeed. Index funds seek merely to match a benchmark with a low-cost, passive approach. Their target investors also differ: Hedge funds are more suited to wealthy individuals and large institutions with higher tolerance for risk, while index funds are designed to appeal to average investors.

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