Hedge Funds, Buffett, and Dumb Luck

By: Matt Garrott
By: Matt Garrott

As usual, Warren Buffett’s letter to shareholders of Berkshire Hathaway is a must-read.  It is well known that he advocates low-fee indexing for most investors.  As his famous bet with a hedge fund of funds manager winds down, Buffett unleashed both barrels on high-fee money managers:

“The underlying hedge-fund managers in our bet received payments from their limited partners that likely averaged a bit under the prevailing hedge-fund standard of “2 and 20,” meaning a 2% annual fixed fee, payable even when losses are huge, and 20% of profits with no clawback (if good years were followed by bad ones). Under this lopsided arrangement, a hedge fund operator’s ability to simply pile up assets under management has made many of these managers extraordinarily rich, even as their investments have performed poorly.

Still, we’re not through with fees. Remember, there were the fund-of-funds managers to be fed as well. These managers received an additional fixed amount that was usually set at 1% of assets. Then, despite the terrible overall record of the five funds-of-funds, some experienced a few good years and collected “performance” fees. Consequently, I estimate that over the nine-year period roughly 60% – gulp! – of all gains achieved by the five funds-of-funds were diverted to the two levels of managers. That was their misbegotten reward for accomplishing something far short of what their many hundreds of limited partners could have effortlessly – and with virtually no cost – achieved on their own.”

With one year to go, the bet is all but won.  The S&P 500 is up an annualized 7.1% vs the fund of funds’ 2.2%.  Cumulatively, the S&P 500 is up 85% vs the fund of funds’ 22%.

While the S&P 500 is leaving the hedge funds in the dust now, it is important to note that this was not always the case. In fact, the hedge funds were ahead for the first four years of the bet.  The S&P 500 lost 37% in the first year (the hedge funds lost “only” 24%) amid massive market turmoil.  As Buffett “bought America”, the intelligentsia wondered aloud if he had finally lost his touch.  This was the time of the New Normal, Black Swan, and Dead Cat Bounce.

America recovered and once again Buffett looks like a genius.

Don’t forget the unheralded hero of the bet: the collateral. Buffett and Protégé (the fund of funds company on the other side of the bet) each put down collateral in the form of a zero-coupon government bond that would equal $500,000 at the end of 10 years (awarding the winner’s charity $1 million).  However, in 2012, while the S&P 500 and the fund of funds were both floundering, the value of the collateral had risen over 50% due to falling interest rates.  The contestants in the bet agreed to sell the bonds and invest the proceeds in Berkshire Hathaway stock (valued at about $1.68 million as of December 2014).  The S&P 500 will likely trounce the fund of funds, but the dumb luck of the collateral will probably beat them both.

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Fairway Scorecard 2-28-2017