Buffett versus the hedge funds

The Oracle of Omaha made a very public bet with Protégé Partners on December 19, 2007 that over the following 10 years, an unmanaged S&P 500 index fund would outperform a collection of five high-profile fund-of-funds.

Buffett won the bet and it wasn’t even close. The S&P 500 returned a cumulative 125.8% (or 8.5% per year).

The hedge funds delivered cumulative net returns ranging from just 2.8% to 87.7% (0.3% to 6.5% per year). And remember, this time period includes the 2008 meltdown.




Victory Lap

As Buffett writes in his latest annual letter,

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.



Dreaded Fees

On this count, I can’t argue with the Oracle. One fund delivered annualized net returns of 6.5%, which might be considered competitive with the 8.5% annualized return of the S&P 500 on a risk-adjusted basis.

I say “might” because I don’t have enough information to say definitively either way. But, in my opinion, the performance of four out of the five fund of funds was pathetic.

Investors paid a lot of money in fees and got virtually nothing in return.


Contrarian Take

I’m not, however, willing to throw out the baby with the bath water and eschew all hedge funds.

Depending on your time horizon and objectives, I think certain funds and certain strategies put into practice by funds might be worth a place in your portfolio.

Over the past decade, I’ve placed many of my accredited investor clients in a variety of absolute-return funds invested in everything from medical accounts receivables to option-writing strategies.

And the funds did exactly what I wanted them to do: They reduced portfolio volatility without sacrificing much in the way of returns. They avoided major drawdowns. And importantly, they gave my clients the piece of mind they needed.


Red Lines

I can’t, in good faith, invest 100% of the portfolio of a retirement-aged client in an S&P 500 index fund. That would be irresponsible on a level that should be considered criminal.

But I also can’t, in good faith, invest a significant portion of their portfolio in bonds at today’s yields.

I believe that alternative investments, which would include hedge funds, can — if done right — act as a substitute for traditional bonds.


Key Questions

But in my opinion, the key here is “done right.” When evaluating a hedge fund, I ask myself the following questions:

Does the hedge fund actually hedge, in that they manage risk? Or is “hedge fund” merely code for “aggressive equity trading.”

How large is the fund? I believe there is a sweet spot here. Ideally, you like to see at least $100 million under management. You know that the manager can keep the lights on with the fees generated from a portfolio that size.

But when a fund gets to be several billion dollars, it can be too big to operate in their area of expertise. Just about any strategy becomes unmanageable at a large enough asset size.

Is their strategy — and any hedges they have in place — going to survive a period of significant market turmoil? You generally can’t know with 100% certainty, but it’s useful to know how the fund performed in past periods of volatility.

Is the fund illiquid? And if so, why? If the fund invests in traded stocks or options, it should offer monthly or at least quarterly liquidity. There’s just no reason why it wouldn’t. But if the fund invests in illiquid notes or real estate, then a lockup might be 100% warranted.

Is the fund minimally correlated to the stock market… and to the other alternatives in my portfolio? In my view, there is literally no point in investing in an alternative strategy if it’s just going to follow the rest of your portfolio lower in a bear market.

Buffett is right that most hedge fund managers don’t earn their fees. But I’ll never begrudge a manager for charging a high fee if they’re delivering something I can’t get elsewhere for cheaper.


Photo Credit: DonkeyHotey via Flickr Creative Commons

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Charles Sizemore
Charles Sizemore
Sizemore Capital Management LLC is a registered investment advisory firm located in Dallas, Texas. Charles Lewis Sizemore, CFA is the founder and Chief Investment Officer of the firm.