After eight years, as Buffett gloated at his company’s recent annual meeting in Omaha, the S&P 500 is killing it. The fund Buffett picked, Vanguard 500 Index Fund Admiral Shares (which invests in the S&P index) is up 65.67%; Protégé’s funds of funds—funds that own a portfolio of positions in a range of hedge funds— are up, on average, a paltry 21.87%.

The bet (the stakes will be donated to charity) still has two years to run, so the hedge fund wizards still have some time. But they would need a Herculean comeback. And it’s not too soon to hazard a guess about why Buffett seems to be on the winning side again. If you own a hedge fund that has been underperforming, Protégé’s losing bet may help to explain why—a question worth pondering this week, as some of the hedge fund industry’s most prominent leaders gather in Las Vegas for the annual SALT conference.

The answer starts with the hedge fund industry’s fees, typically 2% plus an incentive, or “carry,” of 20% of the profits. The Admiral Shares, by contrast, charges expenses of only 0.05% a year. That means the hedge funds have to do far better than the index fund just to break even.

In fact, the S&P 500’s returns over the past eight years were only mediocre—about 6.5% a year. But to deliver an equivalent return, net of fees, a typical hedge fund would have had to earn about 9% year. Very few money managers can consistently outperform by 2½ percentage points a year.

But the performance bar for Protégé was even higher, because it chose funds of funds, which superimpose a second level of fees. (The people who select the hedge funds also take a fee.) The exact amount depends on performance; in this case, the Protégé group faced a hurdle, from all fees, of just over 3% a year.

That’s not merely a high hurdle—the law of averages suggests it’s near to impossible to clear. Start with the fact that it’s harder to pick five stellar funds than one. And each fund of funds is invested in many underlying hedge funds. Most likely, the Protégé group is invested in well over 100 individual hedge funds. The chance of identifying 100 truly stellar funds is close to zero.

Each of the individual hedge funds is itself diversified, owning 30 to 50 or even more securities. Allowing for overlap, the Protégé Group probably owns more than 1,000 different securities in all. That would make it pretty close to an index fund–only with super-high fees.

Given all this, I would say Buffett’s bet amounted to a sure thing. Here’s what interesting. Ted Seides, the former Protégé partner who took the other side of the bet, told me that over the eight years, his funds of funds have delivered a gross return of 49%, about 5% a year. In other words, even ignoring fees, all their talent and hard work underperformed a mechanical index.

That’s hardly a cause for shame. Many actively managed funds underperform. (I’m on the board of a mutual fund, the Sequoia Fund, which has slightly lagged the index over 10 years.)

But it’s important to understand why Seides’s bet was almost doomed from the outset. Extreme diversification inevitably drives results toward the mean.

At the annual meeting, Buffett said the results demonstrate the value of being “slothful,” i.e., patient, as opposed to hyperactive. Trading costs money, and moreover, investors who churn their portfolios are likely to trade in and out at ill-advised moments. Perhaps a very few can trade with skill but, as we’ve observed, a group of 100 or more hedge funds will not have that skill.

Put differently, short-term traders are less likely to be thinking in terms of a security’s fundamental value. We don’t know that this happened with the Protégé group. But hedge fund managers say that, typically, funds of funds are their worst investors—the most skittish, the most prone to dart in or out to chase returns. And a post from Seides on the CFA Institute Enterprising Investor blog last year gave cause for concern. This was Seides describing what, other than fees, contributed to the Protégé group’s underperformance:

“The something else can be discovered when breaking down the components of a hedge fund’s return. Stated simply, the return earned by a hedge fund is a function of the beta embedded in the strategy, the return on cash balances, the alpha from security selection, and the fees and expenses incurred along the way.”

There is nothing “simple” about that statement, and also nothing that implies a helpful or enlightened understanding of investing. “Alpha” and “beta” are contrivances invented by academics and marketed by consultants, often for the purpose of steering institutions into funds of funds. They are not “embedded” in securities; they are calculated after the fact. When you invest in Facebook, the stock doesn’t come with a sticker that says, “Here’s the alpha, here’s the beta.”

Investors who focus on such constructs are suffering from a delusion that mathematizing prior returns will unearth some formulaic verity that will necessarily persist in the future. And they ignore the wisdom imparted by Benjamin Graham (Buffett’s teacher at Columbia Business School)—that stocks are shares of a business. They do not have “components”; they are not Greek symbols, or Ouija board mysteries, or numbers choreographed according to some secret logic across the modern equivalent of a ticker tape. They are legally binding promises guaranteeing investors a pro-rata share of the business’s dividends. Over the long term, people who own those shares will prosper, or not, in accordance with the underlying businesses.

Seides told me he made the bet as a “referendum” on the S&P 500. The market since then, he elaborated, “vastly outperformed” his expectations. That should tell you to beware of market forecasts. But it also should make you wary of “hedging” as a strategy.

Many (not all) hedge funds deliberately try to balance long and short investments. They do this, usually, not because they are either bullish or bearish, but because they do not want to be exposed to downturns. However, except in the case of a manager who is exceptionally talented, such a strategy will tamp down total returns. In a rising market it will tend to give up gains, just as it will lessen losses in a falling market.

Since the market, over time, does rise, this sort of deliberate hedging amounts to an insurance premium that will decrease long-term returns.

Let’s review: it takes a smart manager to beat the average. You have to be really smart to beat it net of fees. And many funds resort to short-term trading strategies inconsistent with fundamental investing, or hedging that dampens volatility.

It’s no wonder the Protégé bet is having trouble. If Protégé, with its 100 or so underlying hedge funds, can’t beat the market, is it any surprise that the universe of hedge funds (of which there are some 10,000) has trailed for many years?

I am not, at all, disputing that superior managers can and do beat the market. But if you want to try, stick your marbles in one fund, maybe three. And make sure they are focused on evaluating stocks for what they are—as shares in a business.

Roger Lowenstein’s most recent book is America’s Bank: The Epic Struggle to Create the Federal Reserve. He owns stock in Buffett’s Berkshire Hathaway.