Friday, February 6, 2015

Buffett's Hedge Fund Bet

Warren Buffett made a bet quite a while back with Protege Partners, LLC. He bet that, over ten years, an S&P 500 index fund* would outperform a basket of hedge funds chosen by Protege.

The bet started in 2008 and goes through 2017.

Well, Buffett is well ahead seven years into the bet.

More specifically,it turns out that, seven years in to a ten year bet, so far Buffett is up 63.5% while Protege Partners is up an estimated 19.6 % (this is an estimate because some of the funds returns are yet to be finalized).

Here's an excerpt of Buffett's argument: "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."

And an excerpt of Protege's argument: "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."

So Buffett is betting on a more passive approach while Protege is advocating a more active approach. A charity of the winner's choosing will get $ 1 million once the bet has been complete. It turns out that Buffett and Protege initially put $ 320,000 each into a zero-coupon bond with the idea that its value would be roughly $ 1 million when it came time to donate the money. Well, both sides agreed -- after the zero-coupon bond did rather better than expected due to the substantial drop in interest rates -- to sell the zero-coupon bond in 2012 and put the money into Berkshire Hathaway's (BRKbClass B common stock.
(Buffett has apparently promised to pay the full amount if the stock ends up being worth less than $ 1 million at the end of the bet.)

In fact, Berkshire's stock has rallied quite a bit since they made that switch. The value currently sits at $ 1.68 million. So the initial investment by both Buffett and Protege seems rather likely to be worth much more than $ 1 million once this bet is settled.

Buffett wrote the following in the 2013 Berkshire letter:

"...the 'know-nothing' investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.

If 'investors' frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties."

Consistent with this thinking, he has instructed a more passive investment approach for his wife's future benefit:

"My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.)"

Buffett has previously made a similar point. He thinks that many investors would end up better off if they simply bought index funds on a periodic basis. John Bogle and others seem to think along the same lines.

The emphasis being on increases to intrinsic value and long-term effects instead of cleverly timing price movements. It's generally foolish to try and time the market (or, for that matter, an individual stock) though obviously that doesn't stop many from trying to do so.

Attempts at clever timing tend to subtract from results.

Act accordingly.

Stocks, in general, seem not at all cheap these days. That doesn't make it time to sell. To me, it means lowering expectations and learning how to deal with the inevitable but unpredictable price moves. Substantial price moves may be inevitable, but it's nearly impossible to know when and by how much. Stocks (and funds) will drop dramatically from time to time. What's expensive goes on to become even more expensive. So assume that predicting near-term price moves is nearly futile.

Better to expend energy elsewhere.

Those who can't handle the fluctuations -- sometimes driven more by psychology than fundamentals -- likely won't do all that well in stocks or funds. Too often, they end up buying and selling at inopportune times.

So trying to time price action is not a solution; it likely creates more problems than it solves. Now, for those inclined/able to judge price versus value and in a position to act decisively, the next big decline should be viewed as an opportunity. Pay sensible prices and simply expect, ignore, or even benefit from the price action. The price paid is in an investor's control; most everything else is not. If a good business is bought cheap and intrinsic value increases at a satisfactory rate, those fluctuations should over time increasingly look meaningless once the weighing machine asserts its influence. What about those who don't feel comfortable judging business economics and whether a particular enterprise has real durable advantages? Well, as Buffett has pointed out, they can do just fine as long as they recognize their own limits.

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."

Excessive buying and selling, even if thoughtful and well-intentioned, will too often just create unnecessary frictional costs (taxes, commissions, etc.) with little benefit otherwise.** The same goes for the fees that are typically charged by hedge funds. Those costs are incurred by investors -- transferring wealth in the process -- whether there's lots of trading activity by the fund or not.

Of course, it's not as if there aren't a large number of investors who are capable of doing very well owning individual stocks. Many, in fact, do very well.

Buffett once wrote that those who are "able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages," can do just fine.

It's just that too many also have an unwarranted confidence in their own capabilities especially once all the frictional costs are taken into account. Lots of incremental effort with no incremental benefit (or, in enough cases to at least be of interest, returns that are made worse by all the activity).

As a result, the vast proportion of market participants -- and it's not just the amateurs -- can't match the performance of a minimal effort required low-cost index fund that's bought periodically, almost never traded, and held for the long-term.

The emphasis is on how the business (or businesses) increase intrinsically in value instead of trading the price movements or, as Buffett calls it, attempting "to dance in and out".

Long-term investors in individual common stocks need not have some special talent for trading; they need to understand how price compares to value; they need to have the patience to wait until the price-value comparison is hugely in their favor and stick to owning what they truly understand.

Sounds simple enough.

In many ways it actually is.

It's just not all that easy.

That's because the simplicity is deceptive.

Lots of discipline and hard work is still very much required.

Important qualitative and quantitative elements must be carefully considered.

Psychological factors that can impact results must be understood then managed or, at the very least, the damage that various biases can do needs to be contained.

They aren't just someone else's problem.

Also, temperament come into play.

Common stocks can make sense for those who feel comfortable judging and valuing individual businesses; index funds make more sense for those who do not.

Some will overestimate their own ability to pick stocks consistently well; they'll end up doing a bunch of work that adds nothing to returns and might even subtract. With individual stocks, it's far more likely that big and costly mistakes -- including substantial permanent capital loss -- will be made.

With index funds, psychological biases and temperamental factors still matter; discipline is still required.

Otherwise, index funds should require a whole lot less work and far fewer difficult judgments compared to stocks.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
The Curse of Liquidity
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
Buffett on "Asset Gathering" vs "Asset Managing"
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
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
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Recent Study on Investor Returns
When Genius Failed...Again
Best Performing Mutual Funds - 20 Years

* Vanguard 500 Index Fund Admiral Shares (VFIAX).
** Excessive activity can also lead to mistakes. Each move is an opportunity to improve results; it's also an opportunity to make things worse. It's easy to put too much emphasis on the former while giving too little consideration for the latter.
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