USA TODAY - When one of the world's richest men provides free money tips, it's worthwhile to pay attention.
Warren Buffett does so in the chairman's letter contained in Berkshire Hathaway's latest annual report, offering a strong vote of confidence for a blue-collar investment vehicle.
As with past Buffett essays, his most recent narrative, penned Feb. 25, provides valuable insights mixed with a prosaic discussion of Berkshire Hathaway's operations. That's part of Buffett's literary style — spin yarns, go off on tangents, keep it simple.
Buried deep in the 27-page letter, Buffett recounted how he initiated a long-term wager nearly a decade ago and now has nine years of performance data that will determine who wins the bet. Back then, he staked $500,000 to support his view that a mutual fund holding stocks in the Standard & Poor's 500 index would beat a representative sampling of hedge funds. Only one hedge-fund proponent, an investment manager named Ted Seides, took him up on it on the wager, choosing five portfolios that each invested in 20-plus hedge funds.
All performance results, the two agreed, would be measured net of fees, as is standard practice.
This was a blue-collar vs. white-collar proposition, a contest pitting a mainstream investment against portfolios reserved for the wealthy. Index mutual funds, open to anyone with a couple thousand dollars or less, are designed for the masses. Hedge funds, by contrast, are reserved for "accredited" investors — basically, people with incomes of $200,000 and up or net worths exceeding $1 million — and run by some of Wall Street's sharpest minds. With one year to go, barring a market meltdown, Buffett's bet looks like a winner.
Over the prior nine years, from 2008 through 2016, the blue-collar S&P 500 index fund appreciated 85.4% including reinvested dividends, beating all five funds that Seides selected (each was a portfolio investing in 20 or more individual hedge funds, as noted). The best hedge fund-of-fund rival was up 62.8% over the nine years, according to Buffett's accounting, giving the latter a commanding lead.
Hedge-fund managers have a lot more tools at their disposal than mainstream mutual funds. They typically can buy stocks long or sell them short, invest in currencies, commodities or other assets, trade options or — in short — seek out opportunities wherever they spot them. Index funds do just one thing — buy and hold the same stocks represented in the market index or basket that they track.
So why have the hedge funds lagged so badly? In part, it's because their managers do try to outperform the market and often mess up, Buffett noted. In addition, the funds typically charge lofty expenses that include a fairly standard 2% annual bite plus 20% of any profits realized. A typical index fund, in comparison, charges around 0.2%, possibly a bit less, and the fund's management team doesn't take a slice of the shareholders' capital gains.
As part of the bet, Buffett agreed not to disclose the names of the funds or the hedge funds they held, so we have to take his word that the performance numbers are accurate (he indicated he gets to view the audited results). Of significance, Buffett structured the bet by pitting his S&P index fund against the average results from multiple hedge funds. That was an important condition because it minimized the possibility that one hot hedge fund, by itself, could hit paydirt and win the wager. Rather, this was a bet comparing multiple hedge funds against the overall stock market, as represented by the 500 or so largest corporations.
The comparative results say a lot about the eroding effects that expenses can exert and the futility of active portfolio management. "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients," he observed.
Buffett's hedge-fund competition has deeper significance, as it says a lot about human behavior and psychology. In many respects, as Buffett acknowledged, the wealthy do receive the best products and services. But this isn't necessarily the case when it comes to investing. In fact, this expectation of superiority can work against the rich.
"The financial elites — wealthy individuals, pension funds, college endowments and the like — have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars," he wrote. "The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket — you name it."
But it isn't necessarily so in the investment world, Buffett argued, pointing to the hedge-fund contest as evidence. If anything, he cautioned upscale individual and institutional investors to beware the many advisers and consultants who play to these presumptions.
Buffett recounted that many people have asked him for investment advice over the years, to which he has regularly recommended low-cost index funds such as those holding stocks in the S&P 500.
"To their credit, my friends who possess only modest means have usually followed my suggestion," he said. "I believe, however, that none of the megarich individuals, institutions or pension funds has followed that same advice when I’ve given it to them."
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