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Adam Smith Explains Why Warren Buffett's Hedge Fund Bet Could Work

Warren Buffett made a bet about the relative performances of hedge funds and index funds, that the index funds would beat the performance of a fund of hedge funds, over a decade. And as the FT is reporting it looks as if he might well win that bet (note that this is a prediction and bet by Buffett, not a bet that he’s made with Berkshire Hathaway's Berkshire Hathaway's money). Quite the most interesting thing to me about this is that we can turn to the grandaddy of economists, Adam Smith, for an explanation of why this might be so. Here’s the report:

Nomura, as part of an excellent report looking at various aspects of active versus passive investment management, have considered Warren Buffett’s famous bet that an index fund will beat a fund of hedge funds over ten years.

Buffett is winning, and the bank’s conclusion is that this is very far from a fluke.

Now if you want their explanation of why it’s not a fluke, along with charts and all sorts of nerdy deliciousness, then read Alphaville’s post. My explanation, drawing upon Smith, is rather different.

Recasting Smith’s 18 th century prose into modern jargon, all capitalists (and hedge funds are definitely capitalists) are looking for economic profits. That’s profits over and above the general return to capital (however you want to do the risk adjustment there is fine). Further, when some capitalists find such a method of making economic profits then all of the other capitalists similarly looking jump into the same field. This competes down that economic profit, often to below the level of the normal return to capital. It’s this that produces the great boom and busts of investment in particular sectors as time goes on.

OK, now think about what it is that hedge funds do. They’re operating in a short term manner looking for those economic profits. Usually, but not always, through arbitrage (the buying and selling of the same thing in different markets to take advantage of pricing differences). There are more complex options like time arbitrage but the essential point here being that they’re short term and hunting those economic profits.

Now some of them obviously do find them: John Paulson most certainly did with mortgages but then most decidedly did not the following year with gold. But that whole ecosystem of hedge funds is obviously competing among itself to find those economic profits. They’re very good at it: but that very competition means that no one fund, no collection of funds, is going to continually generate those economic profits. Simply because there are too many other people competing for the very same thing.

In a systemic sense this is just great for the rest of us. By locating, trading upon and thus eliminating those sources of economic profit they’re all making the economy more efficient for the rest of us. We like that. But of course that’s not so great for the investors in hedge funds because it also means that they can’t consistently produce the outsize returns (really only another name for “economic profit”) that the management charges are justified by.

Or to put it in another Smithian manner: the hedge fund market is simply too much of a free and efficient market for the companies in it to be able to consistently make excess profits. Thus how they can be outcompeted on returns by a low cost index fund.

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