Why Didn’t Buffet Bet On Berkshire?

Warren Buffet's annual letter to Berkshire Hathaway shareholders is eagerly awaited and very carefully parsed by investors and the financial press. The Buffet letter is not an event with which I normally concern myself; however repeated press mentions of Buffet's bet on "passive" investing caught my attention. I have long been focused on relative return of investments as well as the role of "passive" versus "active" management. For the record, I am a strong proponent of active management using passive index funds.

Buffet's relentless criticism of Protégé (much of it admittedly well deserved) led me to examine whether the thrower of stones might also live in a glass house.

In this case, the S&P 500 Index represents the "passive" management and the performance of five hedge funds selected by Protégé Partners represents "active" management. I dug into the letter where Buffet goes on at some length regarding his bet with Protégé Partners:

"Here are the results for the first nine years of the bet ' figures leaving no doubt that Girls Inc. of Omaha, the charitable beneficiary I designated to get any bet winnings I earned, will be the organization eagerly opening the mail next January.

Footnote: Under my agreement with Protégé Partners, the names of these funds-of-funds have never been publicly disclosed. I, however, see their annual audits.

The compounded annual increase to date for the index fund is 7.1%, which is a return that could easily prove typical for the stock market over time. That's an important fact: A particularly weak nine years for the market over the lifetime of this bet would have probably helped the relative performance of the hedge funds, because many hold large 'short' positions. Conversely, nine years of exceptionally high returns from stocks would have provided a tailwind for index funds.

Instead we operated in what I would call a 'neutral' environment. In it, the five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000.

Bear in mind that every one of the 100-plus managers of the underlying hedge funds had a huge financial incentive to do his or her best. Moreover, the five funds-of-funds managers that Ted selected were similarly incentivized to select the best hedge-fund managers possible because the five were entitled to performance fees based on the results of the underlying funds.

I'm certain that in almost all cases the managers at both levels were honest and intelligent people. But the results for their investors were dismal ' really dismal. And, alas, the huge fixed fees charged by all of the funds and funds-of-funds involved ' fees that were totally unwarranted by performance ' were such that their managers were showered with compensation over the nine years that have passed. As Gordon Gekko might have put it: 'Fees never sleep.'

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.

In my opinion, the disappointing results for hedge-fund investors that this bet exposed are almost certain to recur in the future. I laid out my reasons for that belief in a statement that was posted on the Long Bets website when the bet commenced (and that is still posted there). Here is what I asserted:

Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses."

Clearly, the active hedge fund managers appear to be making off with the cream and most of the milk. A 2.2% average annual return to investors for this 9 year period is terrible although I will note that the Bear Market drawdown of "only" 23.9% for the Protégé funds during 2008 was significantly less than the 37% for the Vanguard Admiral S&P 500 Index Fund (VFIAX) selected by Buffet as his benchmark. I ran VFIAX through my software which spit out the following performance summary for the nine years:
A quick look at the table shows that the actual drawdown was much worse than 37%. The Maximum Monthly Drawdown was a whopping 48.4%. I am compelled to wonder how many astute investors would suffer through losing half of their investment before bailing in some combination of fear and disgust.

So how did Berkshire do?

Buffet's relentless criticism of Protégé (much of it admittedly well deserved) led me to examine whether the thrower of stones might also live in a glass house. Once again, I turned to my software which dutifully spit out another table for Berkshire Hathaway Class A shares (BRK-A) for the same period:
BRK-A's Compound Annual Growth Rate of 5.4% significantly lagged the 7.10% of VFIAX; however the Maximum Monthly Drawdown was less at "only" 37.2%. The Monthly Standard Deviation of returns (volatility) for BRK-A was 9.3% less; however Berkshire's returns were 24% lower. Over the course of 9 years, a $100,000 investment in BRK-A would be worth $160,499 versus $185,469 for VFIAX. I assume that loyal Berkshire Hathaway investors hunkered down (sans any dividends) and rode out the steep drawdown with conviction that their hero would prevail over the markets.

Misplaced Adulation

Warren Buffet has made billions for himself and his investors, a level of wealth which have I yet to reach (or aspire) so I would appear to be an unworthy critic. However, I do not find this level of performance worthy of the adulation which is routinely heaped on Warren Buffet.
Unfortunately for investors, it is not just Warren Buffet but the entire Financial Services industry which whitewashes steep drawdowns and sub-par performance to keep the money machine running smoothly.
"What Is Tactical Asset Allocation? How Does It Improve Returns?" is the first topic on our Insights page. The example uses an elementary Tactical Asset Allocation strategy which employs two index funds: Vanguard Total Stock Market Index Fund and Vanguard Total Bond Market Index Fund. A comparative chart and statistical table is included. For the same 9 year period, it produces a 10.5% CAGR with only 10.2% in Maximum Monthly Drawdown vastly outperforming both VFIAX and BRK-A.
I believe we can do better for investors and encourage you to use the links at the bottom of the page to explore the performance of our TAAS Global Strategies to products offered by the Financial Services industry. TAAS Subscribers retain full control of their investments and we do not charge management fees.

 

Earl Adamy

 

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