The Oracle of Omaha made a very public bet with Protégé Partners on December 19, 2007 that over the following 10 years, an unmanaged S&P 500 index fund would outperform a collection of five high-profile fund-of-funds.

Buffett won the bet… and it wasn’t even close. The S&P 500 returned a cumulative 125.8% (or 8.5% per year). The hedge funds delivered cumulative returns ranging from just 2.8% to 87.7% (0.3% to 6.5% per year). And remember, this time period includes the 2008 meltdown.

 Copyright DonkeyHotey

As Buffett writes in his latest annual letter,

The five funds-of-funds got off to a fast start, each beating the index fund in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund.

Let me emphasize that there was nothing aberrational about stock-market behavior over the ten-year stretch. If a poll of investment “experts” had been asked late in 2007 for a forecast of long-term common-stock returns, their guesses would have likely averaged close to the 8.5% actually delivered by the S&P 500. Making money in that environment should have been easy. Indeed, Wall Street “helpers” earned staggering sums. While this group prospered, however, many of their investors experienced a lost decade.

Performance comes, performance goes. Fees never falter.

On this count, I can’t argue with the Oracle. One fund delivered annualized returns of 6.5%, which might be considered competitive with the 8.5% annualized return of the S&P 500 on a risk-adjusted basis. I say “might” because I don’t have enough information to say definitively either way. But I can say with confidence that the performance of four out of the five fund of funds was pathetic.

Investors paid a lot of money in fees and got virtually nothing in return.

I’m not, however, willing to throw out the baby with the bath water and eschew all hedge funds. Depending on your time horizon and objectives, certain funds and certain strategies put into practice by funds might be worth a place in your portfolio. Over the past decade, I’ve placed many of my accredited investor clients in a variety of absolute-return funds invested in everything from medical accounts receivables to option-writing strategies. And the funds did exactly what I wanted them to do: They reduced portfolio volatility without sacrificing much in the way of returns. They avoided major drawdowns. And importantly, they gave my clients the piece of mind they needed.