Warren Buffett’s Hedge Fund Bet

I am a Buffett disciple through and through so it seems odd to some of my close friends that I worked part-time for a hedge fund which charges the exact kind of fees that Warren Buffett has recommended most investors should never pay — 2% management fee and 20% performance fee (2 and 20 in industry jargon).

The 2017 Berkshire Hathaway Annual Report came out this past weekend and it contains the results of a 10-year bet that Buffett made, specifically wagering US$500,000 that “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.”

The result?

“The five funds-of-funds got off to a fast start, each beating the index fund in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund. Let me emphasize that there was nothing aberrational about stock-market behavior over the ten-year stretch. If a poll of investment “experts” had been asked late in 2007 for a forecast of long-term common-stock returns, their guesses would have likely averaged close to the 8.5% actually delivered by the S&P 500. Making money in that environment should have been easy. Indeed, Wall Street “helpers” earned staggering sums. While this group prospered, however, many of their investors experienced a lost decade. Performance comes, performance goes. Fees never falter.

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The bet illuminated another important investment lesson: Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period — or even to look foolish — is also essential.”

Very important lessons for retail and accredited investors indeed.

The biggest lesson though is that you need to pick fund managers in the same way that Berkshire picks investments: diligently and with serious research.

“There are no doubt many hundreds of people — perhaps thousands — whom I have never met and whose abilities would equal those of the people I’ve identified. The job, after all, is not impossible. The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.”

Buffett did not say that no hedge fund manager can beat a passive index fund, just that the person trying to get a share of your investable assets is much more likely to under-perform and so the fees will not be worth it.

Left Brain Capital Management attracted me because they took a very Berkshire Hathaway-like approach to managing their portfolio of investments and the results of the first 2 years have borne out the method — 134.7% in 2016 and 36.18% in 2017, after fees. Will this specific fund continue to beat the S&P 500 over a 10-year period? No one can predict this but as long as they stick to their investment tenets just like Berkshire Hathaway does, it think it is more than likely.

At the end of the day, I agree wholeheartedly with Warren Buffett that paying 2 and 20 for under-performance or the same performance as an index fund is crazy but as long as people keep doing it, there will be someone to take their money.

This is why the average manager should really be charging NO management fee and have a hurdle rate before they can charge a performance fee. If you are so confident in your abilities to beat the market then eat the cooking you are trying to sell.

But I have to keep the lights on, hence the management fee?

Yes a fund manager has costs to operate but they could be covered by a sliding scale management fee as assets under management (AUM) increases. These are mostly fixed costs, not variable costs.

Would I invest in a hedge fund?

Without a doubt the answer is yes, AFTER I carefully evaluate their investment approach, access to opportunities that I may not be seeing, their track record and fee structure.

Blindly saying no to every fund manager merely reduces the pool of fund managers to consider so I look at every single one that approaches me, with a view to finding a reason to say no thanks but being open to investing if it is a good fit.

If I had said no to working with Left Brain, I would have missed out on great investing lessons and another way of thinking about stocks and bonds. Warren Buffett was right about his bet and is right overall but even he admitted that exceptions do exist so I will keep my eyes open for them and you should too.