Hedge Funds vs Index Funds: The Buffett Bet
Hedge funds sell exclusivity, complexity, and the promise of beating the market. A simple S&P 500 index fund beat a hand-picked basket of them over ten years. The fee structure explains most of it.
Don't have time? Here's what you need to know:
- 1Over the 10-year Buffett bet, an S&P 500 index fund (~7-8% annualized) beat a professionally chosen basket of ~100 hedge funds.
- 2The '2 and 20' fee model is one of the widest cost gaps in finance versus a 0.03% index fund like VOO.
- 3By Sharpe's arithmetic, hedge funds start deepest in the hole, and funds-of-funds layer fees on top of fees.
- 4Hedge funds can aid risk management for large institutions, but most retail investors can't access the best ones or beat a cheap index.
What You're Actually Paying For
A hedge fund is the most expensive form of active management available. The traditional fee model is "2 and 20" — roughly 2% of assets every year plus 20% of profits — though competition has pushed many funds somewhat below that. Compare that to an S&P 500 index fund like VOO at 0.03%, and you have one of the widest cost gaps in all of finance. The hedge fund must overcome that gap through skill before its investors see a single dollar of advantage.
Hedge funds also promise something an index fund does not: the ability to short stocks, use leverage, hold cash, and chase returns uncorrelated with the broad market. Some genuinely deliver lower volatility or protection in crashes. But the marketing implies market-beating returns, and on that specific claim the long-run record for the group is poor — the fees are simply too large a hurdle for most funds to clear consistently.
The Bet That Made the Point Public
In 2007, Warren Buffett made a public $1 million wager: that a simple S&P 500 index fund would beat a basket of hedge funds, chosen by a professional fund-of-funds manager, over the following ten years. Protégé Partners took the other side, selecting five funds-of-funds that in turn invested in roughly 100 underlying hedge funds — a wide, professionally curated sample, not a single unlucky pick.
Over the decade ending in 2017, the S&P 500 index fund returned around 7-8% annualized while the basket of hedge funds delivered a small fraction of that after fees. The index fund won decisively, and the winnings went to charity. The bet did not prove that no hedge fund can ever beat the market; it demonstrated that, for a diversified basket selected by experts, the 2-and-20 fee structure overwhelmed whatever skill the managers had.
| S&P 500 index fund | Basket of hedge funds | |
|---|---|---|
| Approximate annual fee | ~0.03-0.05% | ~2% + 20% of profits |
| 10-year annualized return | ~7-8% | A small fraction of that |
| Selection | The whole index | ~100 funds, expert-chosen |
| Outcome | Won decisively | Lost |
Why Fees Dominate the Outcome
The arithmetic here is the same logic Nobel laureate William Sharpe laid out for all active management. Before costs, the average active dollar earns the market return, because all investors together own the market. After costs, the average active dollar must earn less — by exactly the amount of its fees. Hedge funds carry the highest fees in the business, so as a group they start the deepest in the hole, and the performance fee compounds the problem by taking a fifth of every good year while the bad years are entirely yours.
There is a layering effect too. The Buffett bet ran through funds-of-funds, which add their own fee on top of the underlying hedge funds' 2-and-20 — fees stacked on fees. Even genuinely skilled managers struggle to out-earn that drag consistently, and the skilled ones are nearly impossible to identify in advance. As S&P's persistence research shows for active funds broadly, today's top performers rarely stay on top, so chasing last year's hedge-fund star is close to guesswork.
Tip: When you see a hedge fund's headline return, ask whether it's net of all fees. Gross-of-fee numbers flatter the manager; what reaches your account is what's left after 2-and-20.
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When Hedge Funds Make Sense (and When They Don't)
Hedge funds are not pointless. For very large institutions and ultra-wealthy investors, certain strategies can lower portfolio volatility, hedge specific risks, or provide returns uncorrelated with stocks and bonds — diversification that is worth paying for when you already have more than enough growth exposure. The goal in those cases is often risk management, not beating the S&P 500.
For an ordinary investor building wealth, the case is weak. You typically cannot access the best funds, the fees are punishing, the lockups reduce flexibility, and the odds of picking a market-beater are slim. A low-cost index fund delivers the broad-market return that most hedge funds, as a group, fail to beat — at a fraction of the cost and with daily liquidity. For the vast majority of people, the simple option is also the better one.
Important: Past hedge-fund returns are a poor predictor of future ones, and access to a fund's best years often closes before retail investors can get in. Don't chase a track record you can't reliably repeat.
Frequently Asked Questions
Did an index fund really beat hedge funds?
Yes. In Warren Buffett's 2007 bet, a simple S&P 500 index fund beat a basket of roughly 100 hedge funds (selected by professionals) over ten years, returning around 7-8% annualized while the hedge funds delivered a small fraction of that after fees. The index fund won decisively, and the proceeds went to charity.
Why do hedge funds usually lose to index funds?
Mostly fees. The traditional '2 and 20' structure — 2% of assets plus 20% of profits — is one of the widest cost gaps in finance versus a 0.03% index fund. By Sharpe's arithmetic, the average active dollar trails the market by its costs, and hedge funds carry the highest costs in the business, often layered further by funds-of-funds fees.
Does this mean every hedge fund is a bad investment?
No. Some hedge funds genuinely lower volatility, hedge specific risks, or provide returns uncorrelated with stocks and bonds, which can be valuable diversification for large institutions and ultra-wealthy investors. The point is narrower: as a group, hedge funds have failed to beat a cheap S&P 500 index fund, and picking the rare winner in advance is extremely hard.
Can ordinary investors even access top hedge funds?
Usually not. The strongest funds are often closed to new money or restricted to accredited and institutional investors, and they impose lockups that limit flexibility. By the time a fund's track record is widely known, its best years may be behind it. A low-cost index fund offers the broad-market return with daily liquidity and no minimums.
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Alex Harrington
CFA Level II Candidate, Finance & Economics
Alex Harrington is an independent ETF researcher and personal finance writer with over 8 years of experience analyzing exchange-traded funds. A CFA Level II candidate with a background in economics, Alex has reviewed 800+ ETFs and helped thousands of beginners build their first investment portfolios through clear, jargon-free education.
This content is for educational purposes only and does not constitute financial advice. Past performance does not guarantee future results. Consult a licensed financial advisor before making investment decisions.