Tuesday, June 17, 2008

Buffett's Big Bet


I am a huge fan of index funds. Although investors in Singapore have to pay a relatively higher costs than US investors, it still handily beats many of the high cost funds promoted by banks and 'financial advisors'.

The following is an excerpt from Fortune Magazine, written by Carol Loomis (Fortune's Editor at Large, Buffett's friend and editor of his annual letters to shareholders.
----------------------------------

(Fortune Magazine) -- Will a collection of hedge funds, carefully selected by experts, return more to investors over the next 10 years than the S&P 500?

That question is now the subject of a bet between Warren Buffett, the CEO of Berkshire Hathaway, and Protégé Partners LLC, a New York City money management firm that runs funds of hedge funds - in other words, a firm whose existence rests on its ability to put its clients' money into the best hedge funds and keep it out of the underperformers.
You can guess which party is taking which side.

Protégé has placed its bet on five funds of hedge funds - specifically, the averaged returns that those vehicles deliver net of all fees, costs, and expenses.

On the other side, Buffett, who has long argued that the fees that such "helpers" as hedge funds and funds of funds command are onerous and to be avoided has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protégé has selected.

We're way past theory here. This bet, being reported for the first time in this article (whose author is both a longtime friend of Buffett's and editor of his chairman's letter in the Berkshire annual report), has been in existence since Jan. 1 of this year.

It's between Buffett (not Berkshire) and Protégé (the firm, not its funds). And there's serious money at stake. Each side put up roughly $320,000. The total funds of about $640,000 were used to buy a zero-coupon Treasury bond that will be worth $1 million at the bet's conclusion.
That $1 million will then go to charity. If Protégé wins, it has asked that the money be given to Absolute Return for Kids (ARK), an international philanthropy based in London. If Buffett wins, the intended recipient is Girls Inc. of Omaha, whose board includes his daughter, Susan Buffett.
(see full article here)

The Arguments

Prediction: Over a 10-year period commencing Jan. 1, 2008, and ending Dec. 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.

Warren Buffett: AGREE
A lot of very smart people set out to do better than average in securities markets. Call them active investors.
Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund.

Therefore the balance of the universe - the active investors - must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.

Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor's equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.

A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors.
Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds


Protégé Partners LLC: DISAGREE

Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment.

For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times.

Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.
There is a wide gap between the returns of the best hedge funds and the average ones. This differential affords sophisticated institutional investors, among them funds of funds, an opportunity to pick strategies and managers that these investors think will outperform the averages.

Funds of funds with the ability to sort the wheat from the chaff will earn returns that amply compensate for the extra layer of fees their clients pay.

No comments: