Warren Buffett’s 2017 annual letter to Berkshire Hathaway shareholders was released late last month. One of the topics covered was “The Bet” Buffett made with hedge fund managers on Dec. 19, 2007.
Ten years ago, Buffett challenged any adviser to select five hedge funds and stake $500,000 of their own money betting that their chosen funds would outperform his investment selection of an S&P 500 index fund. The proceeds of the bet would go to charity. At first, there weren’t any takers, but Protege Partners finally agreed to the contest.
Protege is a “fund-of-funds” adviser. A hedge fund-of-funds is a structure that invests in multiple other hedge funds. All told, Protege’s five fund-of-funds owned interests in more than 200 hedge funds.
The final performance results were stunning. The S&P 500 returned 8.5 percent annually over the 10 years, which is in line with historical stock market returns. Four of the five hedge funds delivered annual results between 0.3 percent and 3.6 percent. The best-performing hedge fund came in at 6.5 percent. On a cumulative basis, you really get a feel for how poorly the hedge funds performed. Cumulative results ranged from 2.8 percent to 42.3 percent over 10 years for the four worst and 87.7 percent for the best fund. The S&P registered a 125.8 percent cumulative return, more than doubling in value.
The hedge funds charged fixed annual fees averaging 2.5 percent compared to a negligible cost for an index fund. Part of the pitch delivered by hedge-fund promoters has always been, sure you are going to pay these managers huge fees, but you are hiring talented money managers whose superior long-term performance will justify their cost. Clearly, over the past decade, most hedge funds have failed to deliver on that claim.
When you consider that hedge-fund fees are often spread around among a host of “placement agents,” including consultants, bankers, brokers and other salespeople steering clients into hedge funds, one begins to understand why the hedge-fund industry has grown to near $3 trillion. Quoting an attorney involved in a hedge-fund lawsuit, “The marketing payments explain why hedge funds have persisted, despite ample evidence that they underperform.”
Lately, it appears some institutions are reducing or eliminating their hedge-fund allocations. The Illinois State Board of Investment recently “zeroed out” its hedge-fund allocation completely. The pension’s chairman, Marc Levine, said “they were confusing and underperforming, with unjustified high fees.” Pension funds in California, New York and North Carolina are also withdrawing from hedge funds. A group of Harvard alumni are arguing that the Harvard Endowment, the largest endowment in the United States, should replace its hedge funds with index funds.
Finally, on a separate topic, Buffett reminds shareholders that short-term price movements in the stock market can obscure longer-term growth in value. Over the 53 years he has run Berkshire Hathaway, the market value of the company has grown 2,404,748 percent. However, during this time, there have been four major price declines in Berkshire stock: -59 percent (1973-1975), -37 percent (1987), -49 percent (1998-2000), and -50.7 percent (2008-2009).
This is a reminder to investors that, periodically, stocks can suffer significant declines. Buffett suggests this is a strong reason to never use borrowed money to own stocks. But in the long run, a good business will recover from those temporary downturns and reward investors with excellent growth in value.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 317-818-7827 or firstname.lastname@example.org.