Warren Buffet claims hedge funds don’t justify their fees. Says investors better off with low cost index funds
Nearly a decade ago, Warren Buffet made a bet with hedge fund manager Ted Seides that the S&P 500 would outperform a basket of hedge funds over a ten-year period. Recently, Mr. Seides conceded he lost the bet, with the basket of hedge funds gaining 22% while the S&P 500 rose by 85%. With this much of a hurdle, there was no way Mr. Seides could win.
This proved to be excellent fodder in Mr. Buffet’s latest investor letter, where he claimed that hedge funds, and other forms of active management was a sucker bet, and investors are better off with low cost passive index funds or ETFs.
While this makes interesting copy in the media, I believe that Mr. Buffet is over simplifying things somewhat. First, the bet was initiated back in 2008, and really since March 2009, the U.S. equity markets have been on a tear. In fact, if you look at the performance of the hedge funds, they outperformed from the start of the bet until nearly 2011, as the equity markets sold off heavily in the aftermath of the global financial crisis. As the Federal Reserve initiated their quantitative easing program, markets have been on a solid run, posting respectable gains in each year, thanks largely to the higher than normal liquidity.
Before we get too far into this, let’s be clear, I would concur with Mr. Buffett that hedge fund fees are very high, with most carrying a 2% management fee, and a 20% performance bonus on positive returns. In comparison, a more traditional equity mutual fund will have an MER of north of 2%, which includes a 1% trailer fee for advisors. For fee based accounts, the management fee is in the 1% range, with operating expenses adding another 30 basis points or so.
I am a big fan of the theory behind hedge funds and other alternative investments. The ones I favour tend to be those that offer equity like returns, with considerably less volatility than a traditional equity investment. Further, they will typically have low or in some cases negative correlation to the traditional indices, which makes them a great diversifier in a portfolio. I am also a fan of active management, particularly when you get managers that are truly active. Unfortunately, often, finding a great hedge fund or a great active manager is often more difficult than it should be. Very few will do what they say they will do, and in the end, you get substandard performance, and are paying a hefty price for it.
But does that mean we should abandon active management or alternative strategies and simply invest in low cost index product? Despite what you may read in the media, there can be a place for active investing.
The biggest complaint about active management is the cost. However, we must be very careful to put cost in a proper context. Yes, costs matter, but they are only one factor of many that should be considered when reviewing an investment. Personally, I prefer to use cost as a tie breaker, where if I’m looking at investments with similar risk reward profiles, I will favour the lower cost option. Obviously, the lower the cost hurdle, the better, when all other things are equal.
But there are other factors that need to be considered. A key factor is the manager, and the investment process used. A good active manager can build a portfolio that can deliver a return that is in line with the broader market, but considerably less volatile, resulting in superior risk adjusted returns.
Another factor to consider is valuation and other fundamental factors. If we look at the valuation levels of the major indices, most are well above their historic averages. In most cases, the higher the valuation, the less we can expect from a forward-looking return expectation. A quality active manager can take advantage of this, and provide a portfolio that offers a superior expected return, compared to the market.
So, does Mr. Buffett winning this bet mean all hedge funds and active managed funds should be avoided. Absolutely not! However, poorly managed funds should be avoided. By understanding what a manager is doing, and how they are doing it, you can gain a solid insight into whether the historic performance trends can be repeated. Costs matter, but it is only one factor, and with all due respect, I would not make an investment decision based on only one factor. Focus on quality, and find the best solution for the asset class you’re trying to access. In some cases, it will be a passive strategy, and in others, it may be an active or alternative strategy product that can offset their costs.