Hedge Funds are a Very Lopsided Arrangement

Warren Buffett is probably THE most quoted person in the investment business.

And the reason for that is…quite literally…simple.

He just has the knack of distilling the complex into the easy-to-understand.

You won’t find out who is swimming naked until the tide goes out.

Be fearful when others are greedy and greedy when others are fearful.

Priceless gems of advice.

An uncanny ability to cut through the spin and BS is why he and Charlie Munger have been so successful.

They are masters at knowing how to clear the smoke and smash the mirrors…providing the clarity needed to make a proper assessment of the issue at hand.

And that talent for calling a spade a spade is evident in this extract from a recent — very long — interview between CNBC Squawk Box host Becky Quick and Warren Buffett.

Becky Quick asked Buffett about the compensation of his two investment managers, Todd Combs and Ted Weschler (emphasis added)…

BECKY: ‘Both of them were managing their own hedge funds before, and the compensation structure in Berkshire is very different than the two and 20 you would get if you were a hedge fund manager.

BUFFETT: ‘That’s right. If they — last year they started with about five billion each. If they’d put it under the mattress under the standard hedge fund arrangement they each would’ve made about $100 million. I mean, that shows you how nutty the arrangement is. But they would have literally made $100 million by sticking it under the mattress. If they put it in an index fund, and gotten the two and 20, they each would’ve made over $300 million. All they had to do was buy the vanguard index. And they each would’ve made over $300 million. They also would’ve gotten more favorable tax treatment on it then they got by getting a salary from Berkshire. So imagine I mean, you can retire forever on $300 million. So one year you go, you put the money in an index fund so it just shows that the — it shows you amounts you get by asset gathering rather than asset managing. I mean even though a great many hedge funds in recent years have not delivered high performance, they’ve delivered high fees.

I love the line ‘asset gathering rather than asset managing. Brilliant.

Attract sufficient funds under management and the ‘two and 20’ fee gravy train will set you up for life.

There’s $100 million on offer just for sticking the money under a mattress…not bad work if you can get it.

Warren Buffett is not the only one to question the value for money proposition offered by hedge funds.

In the December 2015 issue of The Gowdie Letter, I wrote…

In November 2011, former JP Morgan hedge fund insider, Simon Lack wrote a book titled The Hedge Fund Mirage.

On the claim of “absolute return”, Lack asserts that, “In 2008 the hedge fund industry lost more money than all the profits it had generated during the prior 10 years.” 

The excessive fee model has been a gravy train for hedge fund managers.

Lack says hedge fund managers generated gains between 1998 and 2008 of US$449 billion (before fees). From which the investment managers “earned” approximately US$379 billion in fees. The investors received only US$70 billion.

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Hedge funds are shrouded in secrecy

And then there’s this from Monash Business School…

Port Phillip Publishing

Source: Monash University

[Click to open in a new window]

To quote from the paper (emphasis added):

Two working papers from Monash Business School show the [hedge funds] returns are no better than what investors could derive themselves from the broader market, with little justification for the higher fees charged by hedge funds.

The project analysed the results of 5580 hedge funds, of which 2670 were active and 2910 defunct, over the period from January 1994 to September 2010.

…in theory, hedge fund managers will take opportunities “actively” rather than just tracking the broader market. The strategies are based on an individual or team’s expertise to rely on analytical research, their own judgment and forecasts when making investment decisions. However, the research shows this is not the case in practice.

In their Passive Hedge Funds paper the authors find, “the question at the heart of this study is simple: Do most hedge fund managers generate returns through managerial skill? The answer, according to our work, is no.”

Hedge funds are shrouded in secrecy. The theory is the managers want to protect their portfolio positions from being poached by their competitors.

If you believe the Monash Uni research findings, then for most hedge funds, the pilfering of ideas would only be a case of the blind leading the blind.

There you are, locked in an investment fund for at least a month, not knowing where or what your money is invested in. Anything could happen unexpectedly…as we saw early this year.

That ‘event’ could be a good surprise or a bad surprise. If it’s a bad surprise, then your only consolation is the old ‘“too late!” She cried’ catchphrase.

In spite of all the public knowledge on how the majority — but not all — hedge funds are primarily wealth creation vehicles for the owners (and not so much for the investors), the hedge fund industry continues to expand.

The industry is still trading on the folklore created in the 1990s.

Hedge Funds were few and far between. Mutual (unit trust) funds dominated the funds management industry.

The few hedge funds that did exist had a lot of low hanging fruit to pick for themselves.

It didn’t take long for word to get around about so and so making a motza from running a hedge fund.

Then every man and his dog put out a hedge fund shingle. Pretty soon, you had a lot of investment managers trawling over the same ground looking for that elusive ‘diamond in the rough’.

In order to stand out from the crowd it meant you had to take outsized risks…bet big on a particular strategy. If it worked, you gathered more assets.

If the hairy-chested bet failed, you could still milk the remaining portfolio for at least 2% and in the occasional month when you did outperform the benchmark, pick up your 20% performance fee.

There are harder ways to earn a seven-figure income.

The field is so crowded with hedge funds these days that most of them are kicking over the same stones. Very few have a value-add proposition…for the investors that is.

Let me leave you with another piece of sage advice from Warren Buffett.

The downside to index funds…

As reported in Business Insider (emphasis added):

A low-cost index fund is the most sensible equity investment for the great majority of investors,” Buffett told [Jack] Bogle in his book “The Little Book of Common Sense Investing.” “By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals,” Buffett said.

  • Index funds DO NOT pretend to be smarter than the market.
  • Index funds operate on wafer-thin margins…as low as 0.1%.
  • Index funds have daily liquidity.
  • Index funds outperform nearly 90% of professional mangers over the long term.

The only downside to index funds is they’re boring. And that’s where hedge funds have the edge…they are perceived as sexy and have that allure of offering more.

That’s the illusion. The reality is they could ‘put it under the mattress under the standard hedge fund arrangement they each would’ve made about $100 million.

As determined by numerous studies, hedge funds — in the main — are a very lopsided arrangement.

The management tends to do very well, whereas the investor experience…well, that’s not always as rewarding.

In my experience, going with the simple, transparent and low percentage index funds are, ironically, the high-percentage play.


Vern Gowdie Signature

Vern Gowdie,
Editor, The Rum Rebellion

Vern has been involved in financial planning since 1986.

In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.

His previous firm, Gowdie Financial Planning, was recognised in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia.

In 2005, Vern commenced his writing career with the ‘Big Picture’ column for regional newspapers and was a commentator on financial matters for Prime Radio talkback.

In 2008, he sold his financial planning firm due to concerns about an impending economic downturn and the impact this would have on the investment industry.

In 2013, he joined Fat Tail Investment Research as editor of Gowdie Family Wealth. In 2015, his book The End of Australia sold over 20,000 copies and launched his second premium newsletter, The Gowdie Letter.

Vern has since published two other books, A Parents Gift of Knowledge, all about the passing of investing intelligence from father to daughter, and How Much Bull can Investors Bear, an expose on the investment industry’s smoke and mirrors.

His contrarian views often place him at odds with the financial planning profession today, but Vern’s sole motivation is to help investors like you to protect their own and their family’s wealth.

Vern is Founder and Chairman of The Gowdie Advisory and The Gowdie Letter advisory service.

The Rum Rebellion