Do Hedge Funds Really Outperform?
I always look forward to reading Warren Buffett’s Annual Letter to shareholders of Berkshire Hathaway stock. The main reasons I enjoy reading the letters are because they are very clear, easy to understand and full of investment wisdom from an investing icon. (A link to the webpage with each letter appears at the end of this article.)
This year’s letter was especially informative. You may remember 10 years ago Mr. Buffett made a well-publicized bet with Protégé Partners, a fund-of-funds that handpicks and invests in hedge funds. He initially offered his bet to anyone, especially anyone on Wall Street, but Protégé Partners was the only company willing to accept the bet.
The bet was simple. Protégé Partners could select a minimum of five hedge funds, including their own. Mr. Buffett bet them $1,000,000 (to go to charity of choice) that none of the hedge funds could outperform a simple S&P 500 index fund for the 10 year period.
Mr. Buffet’s argument was that popular, high-fee investment vehicles (hedge funds) could not deliver on their promise of superior returns. The typical fee arrangement when investing in hedge funds is a “2 and 20” model, which simply means they charge a 2% management fee and they also keep 20% of the profits they generate. Buffett has long taken issue with hedge funds’ promise of outperforming the market and their high fees that diminish their clients’ returns.
December 2017 marked the end of the bet, and the results speak for themselves:
Over the ten year period, the S&P 500 index fund returned 125.8%. The five hedge funds returned 87.7%, 42.3%, 27.0%, 21.7% and 2.8% respectively. I would imagine Protégé Partners tried to pick some of the best-run hedge funds in order to win the bet, but none of their picks came close to matching Mr. Buffett and the simple S&P 500 index fund.
In order to ante up for the bet, both Mr. Buffett and Protégé Partners each purchased in face value $500,000 worth of zero-coupon bonds that were to mature at the end of the 10 years with a payout of $1,000,000. Ironically, for various valuation reasons, in 2012 both Mr. Buffett and Protégé Partners agreed to sell the bonds and place the money in Mr. Buffett’s Berkshire Hathaway stock for the remainder of the bet. The final tally was far more than $1,000,000. It turned out to be $2,222,279 that went to charity due to appreciation in Berkshire stock.
At the end of the day, Mr. Buffett’s wager highlighted investing discipline. Investors like you and me are inundated with the new “latest and greatest” investment ideas. We see commercials on TV, hear commercials on the radio, read advertisements and sometimes get sales calls. The old saying, “If it sounds too good to be true…” nearly always applies. The secret to successful investing is not based on successfully timing and navigating the thousands of investment ideas out there – or having a hot stock tip or two. Successful investing involves good stewardship, discipline, diversification and a plan.
Link to each year’s Annual Letter – http://www.berkshirehathaway.com/letters/letters.html
