Warren Buffett’s disparagement of hedge funds isn’t news, but many may not be aware that he is ‘putting his money where his mouth is’ these days. The ‘Oracle of Omaha’ and Protégé Partners placed $1 million on a 10-year wager against one another for charity. The bet—Buffett’s money is on a Vanguard S&P 500 index fund and Protégé Partners’ wager is on their chosen five funds.
While we have yet to see who will win, Buffet believes that from 2008 through 2017 the cumulative returns of the broader S&P 500 index fund will outpace the hedge fund. In the eighth year of his bet, Buffet’s thinking may have already been vindicated. As of the end of 2015, the Vanguard S&P 500 index fund yielded cumulative returns of +65.7% versus Protégé Partners’ chosen five funds’ that have returned +21.9%.
With less than two years to go before the wager expires, the results so far suggest the ‘Oracle of Omaha’ will win this bet.
Buffett Derides Hedge Fund Fees
At Berkshire Hathaway’s most recent annual meeting, a wide range of business and political issues were discussed including a highlight from Buffett himself scorning the fees and compensation structure of overpromising hedge funds—as he called it “unbelievable” and a major source of investors’ return dilution. Often times, what you see in the hedge fund industry is an annual management fee plus a percentage of the profits produced for clients. It’s a fee structure that’s almost always higher than what is assessed by traditional asset managers, but the returns don’t necessarily warrant the extra fees. At least, not as of late.
Buffet’s views strongly echo those of the New York City Employees’ Retirement System (NYCERS). After being disappointed with hedge funds’ exorbitant management fees relative to underwhelming returns, the NYCERS pulled out all of its hedge fund holdings—an estimated $1.5 billion portfolio. Similar actions were taken in September 2014 by California’s Public Employees’ Retirement System (CALPERS).
Buffett’s aversion to hedge funds isn’t surprising given his investment discipline. The discipline, similar to that practiced here at Zacks Investment Management, is a long-term approach focused on achieving optimal performance on a risk-adjusted basis. A key here is managing risk. Often, investors do not adequately and systematically factor risk into their investment decisions which can undercut performance over time. Focusing on long-term gains this way is in great contrast to the hedge fund approach that is far riskier and focuses on chasing quick bucks. Berkshire Hathaway’s 2015 annual shareholder letter reiterates the importance of holding onto well-diversified portfolios for the long haul, just as we do here at Zacks Investment Management. In the same letter, Buffett even mentioned that investing in businesses with “terrific economics” could still turn out to be a dubious decision if excessively overvalued.
Buffet’s stance is quite the opposite of hedge funds’ tendencies to chase momentary “hot trends” or “style boxes,” while possibly overlooking company-specific fundamentals along the way. As a consequence, many of these funds undergo distress during volatile times. In 2015, there were 979 hedge fund liquidations, the highest since 2009. This occurred as a result of investors’ decreasing risk appetite amid market volatility, which led them to withdraw from underperforming funds. These cases strongly support Buffett’s views on the vagaries of hedge funds’ long-term potential.
Bottom Line for Investors
Here at Zacks Investment Management, we strongly agree with Mr. Buffett that the discipline of owning quality for the long-term is a winning approach, and our investment strategies reflect this philosophy. We believe that a diversified equity portfolio can produce long-term annualized returns that outperform just about every other asset class.