Buffett winning bet that hedge funds can’t beat market

Bloomberg News  Mar 21, 2012 – 9:42 AM ET

Nelson Ching/Bloomberg

Warren Buffett made a friendly bet four years ago that funds that invest in hedge funds for their clients couldn’t beat the stock market over a decade.

By Katherine Burton

Warren Buffett made a friendly bet four years ago that funds that invest in hedge funds for their clients couldn’t beat the stock market over a decade. So far he’s winning.

The wager that began on Jan. 1, 2008, pits the Omaha, Nebraska, billionaire against Protégé Partners LLC, a New York fund of hedge funds co-founded by Ted Seides and Jeffrey Tarrant. Protégé built an index of five funds that invest in hedge funds to compete against a Vanguard mutual fund that tracks the Standard & Poor’s 500 Index. The winner’s charity of choice gets US$1-million when the bet ends on Dec. 31, 2017.

The Vanguard fund’s low-cost Admiral shares returned 2.2%, with dividends reinvested, from the start of the bet through Feb. 29, as stocks rebounded from a 12-year low in March 2009. The hedge funds fell about 4.5%, based on Protégé’s index returns for the first three years and results since then for the Dow Jones Credit Suisse Hedge Fund Index, which has roughly tracked the group of unidentified funds when adjustments are made for extra fees.

“Hedge funds of funds have underperformed because of high fees and mediocre manager selection,” said Brad Alford, head of Alpha Capital Management LLC in Atlanta, which runs a mutual fund of funds designed to replicate the performance of hedge funds with lower fees and the flexibility for clients to pull money out daily. Since 2009, his Alpha Defensive Growth strategy has posted an annual average return of 8.2%, almost twice the return of hedge fund of funds.

Neither Mr. Buffett nor Scott Tagliarino, a spokesman for Protégé, would comment on the bet’s progress.

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Assets Decline

Funds of funds have seen clients flee in the past five years. Some of the largest U.S. public pension funds, including those in Massachusetts, South Carolina and New York, started investing directly in hedge funds instead of going through an intermediary in an effort to reduce fees and boost returns.

The amount of money they control has fallen by about one-fifth to US$630-billion as of the end of 2011, compared with a year-end peak of US$780-billion in 2007, according to Hedge Fund Research. Funds of funds were the industry’s biggest investors in 2007, holding about 43% of assets.

Mr. Buffett’s argument, like the large pension funds, is that funds of hedge funds cost too much, according to a statement he posted on longbets.org, a website backed by the nonprofit Long Now Foundation that fosters “long-term thinking.” In addition to the 2% management fee and 20% performance fee that hedge funds typically charge, the funds of funds add another layer of fees, on average 1.25% of assets and 7.5% of any gains, according to data compiled by Bloomberg.

Wheat From Chaff

Protégé said in its statement that because hedge funds can make bets on rising as well as falling prices of stocks, bonds, currencies and commodities, they are able to beat the S&P 500 even after fees, and that sophisticated investors such as fund- of-fund managers “with the ability to sort the wheat from the chaff” will earn returns that amply compensate for the extra costs.

The returns of Protégé’s index from 2008 through 2010, reported in Fortune magazine a year ago by long-time Buffett friend and chronicler Carol Loomis, are similar to those of the Dow Jones Credit Suisse Hedge Fund Index, after adjusting for the added fees charged by hedge fund of funds. That index fell 2.5% last year, and rose 4% in the first two months of 2012.

Protégé took the lead in the first year of the bet as its fund of funds index lost 24% and Vanguard’s fund declined by 37%. Buffett narrowed the gap in subsequent years. The S&P fund returned 27% in 2009, compared with a gain of 16% for the hedge funds, according to Fortune. The stock fund rose 15% in 2010 as the hedge funds advanced 8.5%.

Overtaking Hedge Funds

The 81-year-old Buffett, who is chairman of the holding company Berkshire Hathaway Inc., ended last year neck and neck with the Protégé funds as the Vanguard fund climbed by 2.1% and the Protégé hedge funds lost an estimated 3.75%.

The first two months of this year pushed the Vanguard fund ahead as stocks returned 9%, more than twice the gains of hedge funds.

Mr. Buffett, who told Loomis in 2008 he placed his chances of winning at 60%, had originally suggested a bet against single-manager hedge funds. Had he found a taker, he would be trailing by about 6%age points based on the Dow Jones Credit Suisse index.

If Mr. Buffett had bet returns of his own holding company against the performance of hedge funds, he’d be even farther behind. Berkshire Hathaway shares have slumped almost 17% since the end of 2007.

Bloomberg News

http://business.financialpost.com/2012/03/21/buffett-winning-bet-that-hedge-funds-cant-beat-market/

The Individual Investor Advantage

This weekend, as I was driving back from picking up groceries, I was listening to a financial radio talk show. I wasn’t particularly impressed with the host to start with, but then he offered some advice that was so horrible it nearly caused me to veer off the road and into a ditch. He suggested that a caller not invest in stocks, because when you buy a stock, someone smarter than you is the person who is selling it.

Instead, he suggested only investing in mutual funds. Keep in mind; he’s a financial adviser who specializes in mutual funds, so we know where his bias is.

After a few minutes more of listening to the program, I had to turn it off in favor of my daughter’s insipid Kidz Bop CDs. Anyone who followed the host’s advice might as well just flush their money down the toilet.

Here’s why.

Most mutual funds underperform the market. In 2011, 84% of stock mutual funds did not beat the broad market or their benchmark index (if a fund is focused on a particular sector like technology or a region like Europe, it will have a different index that it’s expected to beat other than the S&P 500).Last year was a particularly bad one for mutual fund managers. Normally, the results aren’t quite as dismal. Over the past 10 years, 57% of funds underperformed their benchmark.

To make the radio host’s argument even more laughable, he said those “smart” traders on the other side of the stock trades included many mutual fund managers who did this for a living.

So you should be scared of buying stock from people who are bad at their jobs? Forget that. Where do I sign up to buy from them?

The weak performance of mutual funds doesn’t mean you should avoid all mutual funds. They’re appropriate for investors who don’t like to pick their own stocks and don’t want to put much effort into their portfolio other than asset allocation. But be sure you don’t chase a hot mutual fund because it posted strong performance numbers or has a popular manager.

Instead, invest in index funds with low expense ratios. If you’re investing in index funds, you’re basically just trying to match the market averages. There’s nothing wrong with that. The market goes up over the long haul and if you’re matching the market’s performance, you’ll make money.

If you’re investing in mutual funds, consider the funds in Alexander Green’s Gone Fishin’ Portfolio. These are funds like the Vanguard Emerging Markets Index Fund (VEIEX). The fund has a very low 0.33% expense ratio and has returned an average of 13.11% per year over the past 10 years.The key to the funds in The Gone Fishin’ Portfolio are the very low fees. Many actively managed funds have significantly higher costs — usually at least 1%, and sometimes much more. That means each year 1% or more of your money is going to the mutual fund company to pay for salaries, toner and Christmas parties. That money is better off in your pocket and the lower fees will improve your returns over the years.

This doesn’t mean that there are no quality mutual funds or managers who will generate solid returns for you — but with six out of 10 fund managers underperforming the market every year, are you really good enough to pick the right one every year? I’m not. That’s why most of my mutual fund holdings are in the funds recommended in The Gone Fishin’ Portfolio — inexpensive funds that are designed to simply match the market returns.

But I don’t put all of my money in those funds. I pick stocks, too. And I’ll match wits with those fund managers any day of the week. It’s not that I’m so smart and they’re so dumb. But as an individual investor, I have opportunities that they don’t.

Individual investor advantagesFor example, a stock I like that’s currently in The Oxford Club’s Perpetual Income Portfolio is Community Bank System (NYSE: CBU). It’s a small bank located in upstate New York and Pennsylvania. It has a market cap of just over $1 billion and trades an average of 244,000 shares a day.

I like it because it never took a dime of TARP money, pays a 3.6% dividend yield (4.7% based on our entry price in September) and has raised the dividend every year for 19 years.With just 244,000 shares traded per day, a large mutual fund would have difficulty buying large blocks of stock without moving the share price significantly. As an individual investor, you would have no problem picking up a few thousand shares on any given day.

Also, as an individual investor, you don’t have to worry about marketing. You’re not trying to impress anyone with which stocks you own or trying hard to beat a benchmark. However, a mutual fund, particularly one that isn’t outperforming, better have some of the hottest stocks in its portfolio at the end of the quarter, when its portfolio is revealed, otherwise, as Ricky Ricardo used to say, they’ll have some “’splainin’ to do.”Additionally, they’ll get rid of their dogs. The fund companies don’t want investors pulling their money (which reduces fees collected) because investors think the fund managers are asleep on the job. But buying hot stocks and dumping beaten up ones is usually the wrong thing to do.

If the fund manager has done his homework and likes a stock because of its prospects and/or value, selling it because it sold off and is cheap isn’t going to help investors in the long run. He should be buying. And similarly, if a stock is hot and is a momentum trade, buying it after it is popular is also misguided, as it may be difficult to sell so many shares from a big fund when the music stops.

Individual investors have more flexibility than the big guys. You don’t have to publish quarterly reports that will be scrutinized and you can get in and out of stocks whenever you want, without fear of moving the price. You can also switch your strategy at any given time.

If you decide small caps look more attractive than large caps, you can move some of your assets between the two groups, whereas a large cap fund manager is stuck in large caps, no matter how the group is performing.

Even if you’re an investor who doesn’t want to actively manage your money, don’t be lazy and hand it over to a mutual fund manager who will likely not do as good a job as you or a passive index fund will. Pick some great stocks that you expect to hold for the long term, or buy the funds mentioned in The Gone Fishin’ Portfolio. You’ll save a ton of money in fees and likely do a better job than the fund managers do. It would be hard to do worse.

Marc Lichtenfeld is the Senior Analyst at InvestmentU.com

http://www.investmentu.com/investment-experts/marc-lichtenfeld.html

Guest Lecture by David Swensen: Investment Management (Yale lecture)

Uploaded by YaleCourses on Nov 19, 2008

Financial Markets (ECON 252)

David Swensen, Yale's Chief Investment Officer and manager of the University's endowment, discusses the tactics and tools that Yale and other endowments use to create long-term, positive investment returns. He emphasizes the importance of asset allocation and diversification and the limited effects of market timing and security selection. Also, the extraordinary returns of hedge funds, one of the more recent phenomena of portfolio management, should be looked at closely, with an eye for survivorship and back-fill biases.

00:00 - Chapter 1. Introduction: Changing Institutional Portfolio Management
03:59 - Chapter 2. Asset Allocation: The Power of Diversification
16:44 - Chapter 3. Balancing the Equity Bias into Sensible Diversification
20:48 - Chapter 4. The Emotional Pitfalls of Market Timing
32:58 - Chapter 5. Survivorship and Backfill Biases in Security Selection
43:17 - Chapter 6. Finding Value Investing Opportunities as an Active Manager
49:02 - Chapter 7. Yale's Portfolio and Results
54:48 - Chapter 8. Questions on New Investments, Remaining Bullish, and Time Horizons

Complete course materials are available at the Open Yale Courses website:http://open.yale.edu/courses

This course was recorded in Spring 2008.

How to Pick Managed Investments

[PPT] 

How to Pick Managed Investments

www.travismorien.com/investment.ppt

The average American mutual fund investor only managed to earn 2.57%pa .....