Over the ten years from 2008 through 2017, an S&P 500 index fund gained 125.8%. Five funds of hedge funds, chosen by a firm whose business was picking hedge fund managers, gained between 2.8% and 87.7% over the same years. The best of them finished 38 percentage points behind the index. The comparison came from a public bet between Warren Buffett and Protégé Partners, and it covered one decade of mostly rising prices and funds that charged two layers of fees.
An index fund is a mutual fund or exchange-traded fund that holds the securities in a market index, in the same proportions, and charges a small annual fee: 0.05% on average for US index equity mutual funds in 2025. A hedge fund is a private investment partnership, open only to wealthy and institutional investors, that can short sell, borrow and hold illiquid assets, and it charged 1.32% of assets plus 15.78% of profits on average in early 2026.
The legal framework behind the two, the Investment Company Act and the exemptions private funds rely on, is set out in our comparison of hedge funds and mutual funds.
How an index fund and a hedge fund are built
- Goal
- An index fund tries to match its index minus costs, so it falls when the market falls. A hedge fund aims for a positive return in most conditions, within a mandate the manager sets.
- Holdings
- An index fund owns the index constituents, and an ETF must post its full portfolio on its website every business day. A hedge fund can hold short positions, borrowed money, derivatives and private assets, with no daily disclosure requirement.
- Who can buy
- Anyone with a brokerage account can buy an index fund. Hedge funds sell to accredited investors, and funds organized under section 3(c)(7) only to qualified purchasers.
- Cost
- 0.05% a year for the average index equity mutual fund and 0.14% for the average index equity ETF in 2025, against 1.32% of assets plus 15.78% of profits for the average hedge fund.
- Tax reporting
- Form 1099-DIV for a fund shareholder. Schedule K-1 for a partner in a hedge fund.
The eligibility tests come from federal securities law. An accredited investor needs income above 200,000 dollars, or 300,000 dollars jointly, in each of the last two years, or a net worth above 1 million dollars excluding the primary residence. To be charged a performance fee by a registered adviser, an investor must be a qualified client, which since June 29, 2026 means 1.4 million dollars invested with the adviser or a net worth above 2.7 million dollars. Funds organized under section 3(c)(7) accept only qualified purchasers, individuals with at least 5 million dollars in investments. Our guide to accredited investor status explains how each test is checked.
On the index side, Vanguard's 500 Index Admiral Shares generally require 3,000 dollars to open, and an S&P 500 ETF can be bought one share at a time.
Index fund and hedge fund costs in dollars over 10 and 20 years
The table puts 1 million dollars into each structure for 20 years and assumes all of them earn the same 8% a year before fees, so cost is the only difference. The index fund charges 0.04%, the expense ratio of Vanguard's 500 Index Admiral Shares. The hedge fund takes its management fee on assets at the start of each year and its incentive fee on the gain left after that fee, with no hurdle rate and the fund above its high-water mark every year. The last row adds a 1% fixed fee on top of 2 and 20, the extra layer a fund of funds usually charged in Buffett's bet.
| Structure and fees | Net return a year | Value after 10 years | Value after 20 years | Fees paid over 20 years |
|---|---|---|---|---|
| Index fund, 0.04% | 7.96% | 2,151,000 | 4,627,000 | 18,000 |
| Hedge fund at 2026 averages, 1.32% and 15.78% | 5.63% | 1,729,000 | 2,988,000 | 839,000 |
| Hedge fund at 2 and 20 | 4.80% | 1,598,000 | 2,554,000 | 1,036,000 |
| Fund of funds, 2 and 20 plus 1% | 3.80% | 1,452,000 | 2,108,000 | 1,225,000 |
At the 2026 average fees, the hedge fund ends the 20 years with 1.64 million dollars less than the index fund on identical gross returns. About 839,000 dollars of that gap is fees paid, and the rest is the growth those fees would have earned had they stayed invested.
To finish level with the index fund, the hedge fund has to earn about 10.8% a year before fees while the index fund earns 8%, a lead of 2.8 percentage points every year. At 2 and 20 the gross return needed is about 12.0%, and through a fund of funds about 13.2%.
The constant 8% is an assumption chosen to isolate cost. Hurdle rates, a high-water mark after a losing year and negotiated fee discounts change the result fund by fund, and our guide to hedge fund fees works through each of them.
Hedge fund index returns against the S&P 500
The most widely used yardstick is the HFRI Fund Weighted Composite. It averages more than 1,000 single-manager hedge funds with equal weights, net of all fees, back to 1990, and leaves out funds of funds. A fund is included only if its manager submits data to HFR's database, the fund is open to new investment and it has either 50 million dollars under management or a twelve-month track record.
In 2025 the composite returned 12.6%, its best year since 2009, while Vanguard's S&P 500 index fund returned 17.83%. The spread inside the hedge fund index was far wider than the gap between the two averages: the top tenth of funds returned 62.7% and the bottom tenth lost 12.8%.
In 2022, when the Vanguard fund lost 18.15%, the HFRI Macro index gained 9.3%, led by commodity and trend-following funds. The top tenth of all HFRI funds gained an average of 39.1% that year, and the bottom tenth lost 33.0%.
Monthly HFRI figures start as estimates. Each month's value is published twice as an estimate, as late funds send in their numbers, and becomes final with the third release. The second quarter of 2026 was first reported at plus 6.55% and a month later at plus 6.4%.
Survivorship and backfill bias in hedge fund databases
Mutual funds report audited returns to regulators. Hedge funds report to commercial databases only if their managers choose to, and averages built from those databases carry two distortions.
- Backfill bias. A manager can run a new fund on seed capital, start reporting only if the early results look good, and add those earlier returns to the database when it joins. From 1994 to 2003, backfilled returns in the TASS database averaged 14.65% a year against 7.34% for returns reported at the time, a gap of 7.31 percentage points.
- Survivorship bias. Funds that close stop reporting, and an average of the funds still alive leaves out the losers. From 1996 to 2003, surviving hedge funds averaged 13.74% a year and all funds, dead ones included, 9.32%, a difference of 4.42 points. The same comparison for equity mutual funds gave 1.23 points. Earlier estimates of the hedge fund figure ranged from 0.6 to 3.6 points a year.
HFR's archive of funds that liquidated or stopped reporting holds more than 24,000 products from over 5,000 firms, against about 5,700 products in its live database.
Correcting a sample of about 8,400 funds for both biases cut the equal-weighted net return for 1995 to 2009 from 14.88% to 7.70% a year, slightly below the S&P 500's 8.04% over the same 15 years. Of the 11.13% those funds earned before fees, 3.43 points went to fees, 4.70 points came from market exposure, or beta, and 3.00 points was alpha.
Because each month's HFRI value becomes final and is never recalculated, funds that later close stay in the composite's history. The composite still covers only funds whose managers choose to report.
Dollar-weighted returns earned by hedge fund investors
A fund's published return assumes one investment at the start and no money moved afterward. Investors add and withdraw money, and the timing of those flows changes what they earn. Measured with dollar weights, the way an internal rate of return is computed, hedge fund investors earned 3 to 7 percentage points a year less than the funds' buy-and-hold returns. Through the end of 2008 their dollar-weighted returns were below the S&P 500 and only slightly above the risk-free rate.
Buffett's bet against Protégé Partners, 2008 to 2017
On December 19, 2007, Buffett bet that over the ten years starting January 1, 2008, the S&P 500 would beat a portfolio of funds of hedge funds, measured net of fees, costs and expenses. Protégé Partners chose five funds of funds, which together held interests in more than 200 hedge funds, and Buffett named a Vanguard S&P 500 index fund. The winnings, 2,222,279 dollars after the stake was moved from Treasury bonds into Berkshire shares in 2012, went to Girls Inc. of Omaha.
| Fund | Return in 2008 | Total gain, 2008 to 2017 | Average annual gain |
|---|---|---|---|
| Fund of funds A | -16.5% | 21.7% | 2.0% |
| Fund of funds B | -22.3% | 42.3% | 3.6% |
| Fund of funds C | -21.3% | 87.7% | 6.5% |
| Fund of funds D, liquidated in 2017 | -29.3% | 2.8% | 0.3% |
| Fund of funds E | -30.1% | 27.0% | 2.4% |
| S&P 500 index fund | -37.0% | 125.8% | 8.5% |
Every fund of funds lost less than the index fund in 2008. In each of the nine years that followed, the five as a group trailed it, and the index fund rose in every one of those years.
Fixed fees across the two layers averaged about 2.5% of assets a year, and some of the funds also collected performance fees in their good years. Buffett estimated that roughly 60% of all the gains the five funds of funds made over the first nine years went to the two layers of managers.
Protégé's side of the case, posted when the bet opened, was that hedge funds seek positive returns in any market, so they can beat the market in bad years and lag it in the strongest ones. Our guide to what a hedge fund is covers the bet alongside the basics of how the funds work.
Volatility, drawdowns and correlation with stocks
An S&P 500 index fund takes the full fall of the market. The Vanguard 500 Index fund's worst calendar quarter in the ten years to 2025 was a loss of 19.61%, in the first three months of 2020.
Reported hedge fund returns look smoother, and part of that smoothness comes from how positions are priced. Illiquid securities often have no fresh market price at month end, which leaves managers discretion over the mark, and stale prices lower measured volatility and correlation. From January 1994 to September 2000, a broad hedge fund index showed a monthly correlation of 0.52 with the S&P 500 and a beta of 0.37. Adding lagged market returns to the regression raised that beta to 0.84. Long/short equity funds went from 0.55 to 0.99, as exposed to the stock market as an index fund. Once that exposure was hedged out, the index's Sharpe ratio fell from 0.80 to minus 0.40.
In 2008 the funds of funds in Buffett's bet lost 16.5% to 30.1% against 37.0% for the index fund. In 2022 the HFRI Macro index gained 9.3% while the index fund lost 18.15%.
Taxes on index funds and hedge funds
An index fund trades little. The Vanguard 500 Index Fund turned over 2% of its portfolio in its latest fiscal year, so most of its gains stay unrealized until the investor sells. Over the ten years to 2025, Vanguard's 500 Index Admiral Shares returned 14.78% a year before tax and 14.32% after tax on distributions, measured at the highest federal rate. Index ETFs go further: they can meet redemptions by handing over securities in kind, which under section 852(b)(6) of the tax code does not trigger a gain for the fund. In 2025 only 4% of passive ETFs distributed a capital gain, against 41% of passive mutual funds.
A hedge fund organized as a partnership pays no tax itself and passes each type of income through to its partners on a Schedule K-1. Three rules then weigh on a taxable investor:
- Short-term gains. Positions held one year or less produce short-term gains, taxed at ordinary rates that reach 37%, against a top long-term rate of 20%.
- The net investment income tax. A further 3.8% applies above 200,000 dollars of modified adjusted gross income for a single filer and 250,000 dollars for a married couple filing jointly. It applies to index fund dividends and gains too.
- Fees that cannot be deducted. Investment fees, including those passed through from a partnership, are miscellaneous itemized deductions. Individuals have not been able to deduct them since 2018, and the 2025 tax law made that rule permanent. The investor can end up taxed on gains before the management fee is subtracted.
The tax gap between the two index fund wrappers, ETFs and mutual funds, is covered in our guide to ETFs and mutual funds.
Redemptions, lock-ups and daily liquidity
An index mutual fund prices once a day and must pay a redemption within seven days. An index ETF trades on an exchange all day. A hedge fund sets its own terms in its partnership agreement, usually redemptions once a quarter or less with written notice, often after a lock-up, and with a gate that caps how much can leave on one date. Those terms, and the partial view of a hedge fund's portfolio available in 13F filings, are covered in our hedge fund vs mutual fund comparison.
Why institutions still hold hedge funds
Hedge fund capital reached a record 5.6 trillion dollars at the end of June 2026. Investors added a net 115.8 billion dollars in 2025, the most in a calendar year since 2007.
The case for them rests on picking managers from a wide field. A gap of 75.5 points separated the top and bottom tenths of the HFRI in 2025, and 72.1 points in 2022, while an S&P 500 index fund returns the index minus its fee. Our guide to multi-manager hedge funds covers the firms that spread their capital across many trading teams inside a single fund.
Some have left. In September 2014 CalPERS decided to exit its 24 hedge funds and six funds of hedge funds, worth about 4 billion dollars, citing their complexity, their cost and the difficulty of scaling them to the size of its portfolio. It said the decision was not based on the program's performance.
Index fund or hedge fund, by investor situation
- An investor who does not meet the accredited investor test cannot buy a hedge fund directly. Registered funds that run hedge fund strategies with daily liquidity are the available route, listed in our guide to investing in hedge funds with little money.
- Money that may be needed within a year or two can be held up by a lock-up or a quarterly redemption date with advance notice. An index fund pays out within days.
- In a taxable account, a hedge fund's short-term gains can be taxed at 37% plus 3.8%, and its management fee cannot be deducted. Index ETFs rarely distribute capital gains.
- An investor who wants returns that behave differently from stocks in a falling market is paying for manager selection, in a field where the best and worst tenths of funds were 72.1 points apart in 2022.
- The market return itself costs 0.04% a year in Vanguard's 500 Index Admiral Shares, with a 3,000 dollar minimum, or the price of one share in an S&P 500 ETF. The long record of active managers against that benchmark is covered in active vs passive investing.
This article is general information, not investment advice.
Hedge funds and index funds: common questions
Does the S&P 500 beat hedge funds?
The broad hedge fund averages trailed it in 2025, over the ten years of Buffett's bet and, once database biases are removed, from 1995 to 2009. In 2025 the HFRI Fund Weighted Composite returned 12.6% against 17.83% for Vanguard's S&P 500 index fund. In Buffett's bet from 2008 to 2017, the index fund compounded at 8.5% a year and five funds of hedge funds at 0.3% to 6.5%. Hedge funds did better in some falling markets, such as 2008, and the best tenth of funds beat the index in both 2022 and 2025.
What does Warren Buffett say about hedge funds?
When he made his 2007 bet, reprinted in his 2016 letter to Berkshire Hathaway shareholders, Buffett argued that the fees charged by hedge funds and funds of funds would leave their investors, on average and over time, behind a low-cost index fund. He estimated that about 60% of the gains made by the five funds of funds in his bet went to the two layers of managers. For his wife's inheritance, his 2013 letter set out 90% in a very low-cost S&P 500 index fund and 10% in short-term government bonds.
Is Vanguard a hedge fund?
No. Vanguard is an asset manager owned by its funds, which are in turn owned by their shareholders. Its funds are registered mutual funds and ETFs sold to the public. The Vanguard 500 Index Fund Admiral Shares, for example, charges 0.04% a year and generally requires 3,000 dollars to open an account.
Why do hedge funds still exist if most trail the S&P 500?
Their case rests on returns that can move differently from stocks and on the gap between the best and worst managers, which is wide: in 2022 the top tenth of funds in the HFRI gained an average of 39.1% and the bottom tenth lost 33.0%, while the S&P 500 fell. Hedge fund capital reached a record 5.6 trillion dollars at the end of June 2026.