Friday, June 27, 2014

Charlie Munger on Complexity, Hedge Funds, and Pension Funds

Some comments by Charlie Munger from the 2006 Wesco meeting:*

On Complexity
We don't do a lot of involved math... Certainly we expect a decent return or we don't do it. We use a lot of experience and do it in our heads. We distrust others' systems [and complex models] and think it leads to false confidence. The harder you work, the more confidence you get. But you may be working hard on something you're no good at. We're so afraid of that process that we don't do it.

The emphasis is on keeping it as simple as possible (but not too's a balance) and sticking to what they know well.

It's the avoidance of unnecessary complexity and playing to strengths.

On Hedge Funds
Somehow we've created a perverse system of incentives. At Samsung, their meeting of engineers is at 11pm. Our meetings of engineers [meaning our smartest citizens] are also at 11pm, but they're working to price derivatives. I think it's crazy to have incentives that drive your most intelligent people into a very sophisticated gaming system.

A rich system can endure a lot. If 10% of our people over age 60 want to spend X hours per week playing Texas Hold Em, we can afford it. But it's not good. But do we want our auto industry to just crumble away and somebody else's to take over because they do it better? I don't think it's a good outcome. I don't think we can stand a diversion of our best minds to hedge funds.

This may be less than ideal but, considering how lucrative the hedge fund business usually is, it's not terribly surprising. Strong incentives remain in place that likely will continue to divert talent away from more useful things.

For some perspective, hedge fund industry assets under management now stands at $ 2.5 trillion. This is a substantial increase compared to the $ 38 billion that was being managed back in 1990.

On Unrealistic Return Assumptions by Pension Funds
Both Warren and I have said that to predict 9% returns from those pension funds is likely to be wrong and it is irresponsible to allow it. They do it to delay bad news. Look at Berkshire and our paper record, which is obviously much better [than the investment track records of the pension fund managers]: we use 6.5%. For example, the Washington Post has the best record [of virtually any pension fund, yet it assumes a 6.5% annual return].

Munger then goes on to suggest it just might be wise to consider what those who have the best track record have to say over those who do not. These days, too many pensions continue to make unrealistic assumptions about future returns.

The following trend just might end up exacerbating the problem:

How Harvard and Yale's 'Smart' Money Missed the Bull Market

"How did this happen? Well, the average college endowment has just 16% of its investment portfolio in U.S. stocks—half the exposure they had a decade ago. In the years following the Internet bust and then the financial crisis, managers steadily shifted assets to alternative investments like hedge funds, venture capital investments, and private equity."

Recent results haven't been all that impressive but, for the schools highlighted, the longer term results look a whole lot better compared to the S&P 500.**

A similar strategy shift into alternative investments has occurred at corporate and public pension funds.

Big Investors Missed Stock Rally

"Corporate pension funds and university endowments in the U.S. have missed out on much of the rally for stocks since 2009, following a push to diversify into other investments that have had disappointing performances."

Of course, what matters for pension funds and university endowments is the long run results.

What matters is how well their investment policies will work going forward.

It's worth noting that the Washington Post (now Graham Holdings: GHC) -- mostly due to long making reasonable pension promises then producing returns nicely in excess of conservative return assumptions -- continues to have quite a track record.

In fact, the company's pension fund these days sits rather solidly overfunded compared to just about anyone else.

Reasonable promises comfortably aligned with sound investment policy.***

In stark contrast, some seem to have decided to add lots of complexity and frictional costs to their approach.

Complexity that may not at all be needed for achieving desired outcomes.

Costs that, at least in aggregate, create their own headwind.


Very small long position in GHC

Related posts:
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Charlie Munger: Focus Investing and Fuzzy Concepts
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* These comments are based upon notes taken by Whitney Tilson.
** Here's how the returns look for hedge funds, stock-focused funds, and the S&P 500 over the past 10 years: The S&P 500 gained 114% (including dividends), the average hedge fund gained 75%, while the average stock fund gained 68%. Private-equity and venture-capital funds performed much better.
*** Warren Buffett wrote a memo to Katharine Graham in 1975 to guide her on pension obligations and the right investment policy. His input and position on the board for 37 years no doubt has had at least something to do with the company's healthy pension plan. That memo can be found here on pages 118-136. Buffett, in his latest letter, said the following about pension funds and that memo: "During the next decade, you will read a lot of news – bad news – about public pension plans. I hope my memo is helpful to you in understanding the necessity for prompt remedial action where problems exist."
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