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Cry me a river that leads to Omaha

If it takes eight pages, three charts and 25 footnotes to explain why a simple bet is going very wrong, is it effectively a concession of defeat?

The tortured effort by Ted Seides of Protege Partners to rationalize the steep underperformance of his selected hedge funds against the Standard & Poors 500 index is mostly a triumph of excuse-making over self-reflection.

Warren Buffett bet Seides and his partners in 2007 ($1 million initially, to go to charity) that an S&P 500 index fund would do better for investors than a hand-picked assortment of hedge funds over the ensuing ten years. Through Dec. 31, the index fund had gained 7.2% a year, far outpacing the 2.6% return of the hedge funds as a group.

Buffett made the simple — and empirically airtight — point that the heavy fees collected by hedge funds over time will consume more than 100% of the extra return a fund manager is able to deliver. As it turned out, fees did cost some 2.6% annualized from the hedge funds results — but this only deepened the underperformance cause by other means.

With a curious hint of we told you so, Seides eagerly points out that Buffett has, in this respect, been wrong, given that fees alone dont account for nearly all of the lagging hedge-fund performance thus far.

Most of the letter is devoted to logging and lamenting the other factors behind the lopsided score, most of which amount to an argument that the S&P got lucky, and hedge funds were snakebit.

The Fed and other central banks responded to the 2008 financial calamity by dropping rates to zero and keeping them there, driving stocks higher and depriving hedge funds of any income on cash held. The U.S. stock market vastly outran foreign equities, penalizing hedge funds global posture. Structural changes in the arena of borrowing and shorting stocks picked hedgies pockets as they tried to gain downside market exposure.

So, the sharpest, best-connected, most highly compensated tactical predators in the markets (hedge funds) were undercut by central bankers who preferred the world economy didnt fail and technological progress in trading mechanics — and over seven years they failed as a group to anticipate, embrace or maneuver around these shifts.

Those who run funds of hedge funds are, by now, well conditioned to place gentle context around disappointing returns for the asset class, of course. There is little doubt that this bull market has been characterized by copious liquidity that has minimized the value of picking winners from losers, while penalizing risk aversion. These have been headwinds for hedge funds, most of which are built to preserve capital and produce returns through nuanced discernment across the spectrum of assets.

Which lends some support to one excuse that Seides makes: The S&P 500 is a particularly ill-suited benchmark for judging the success of hedge funds. As a long-only index dominated by huge, widely owned stocks and holding no cash, it is a fine vehicle for individuals to gain cheap market exposure.

Not only should a representative group of hedge funds not be expected to keep up with the S&P 500 in a straight-up bull market — an investor shouldnt even want his or her hedge-fund portfolio to do so. And yet, this sophisticated manager of hedge-fund portfolios willingly and confidently bet, in 2007, that they would do exactly that. Even with an index-gutting bear market in between, the hedge funds could not capture and retain an advantage.

Hedge funds are, in some ways, a luxury good — an investment for people who can already afford their cost and dont need them to create heroic returns in order to make them rich.

Seides notes that perhaps now, with indexing surging in popularity, rates poised to rise and many hedge funds reducing fees, the time is approaching for hedgies finally to thrive. He might well be right, for a while.

But would you bet on it for the next decade?