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Warren Buffett vs. the hedge funds
6/27/2017 1:28:01 AM
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DUE DILIGENCE
Objective research, analysis, and insight on investment funds in Canada from an acknowledged industry expert



By Dave Paterson  | Wednesday, June 14, 2017


 



Nearly a decade ago, the legendary investor and CEO of Berkshire Hathaway Inc. (NYSE: BRK.A), Warren Buffett, made a bet with hedge fund manager Ted Seides. He wagered that the S&P 500 Composite Index would outperform a basket of hedge funds over a 10-year period. Recently, Mr. Seides conceded that 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 for Mr. Buffett’s 2016 letter to shareholders, where he claimed that hedge funds and other forms of active management were a sucker bet and that investors are better off with low-cost passive index funds or exchange-traded funds (ETFs).

While this makes interesting copy for the media, I believe that this bet has oversimplified things somewhat. The bet was initiated back in 2008, and the hedge funds outperformed from the start of the bet until nearly 2011. However, once the Federal Reserve Board initiated its quantitative easing program, markets rallied sharply, thanks largely to the higher-than-normal liquidity. Add to this an environment of low volatility and beta-driven rallies, and it makes it tough for most active strategies to outperform.

Hedge fund cost vs. performance

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 management fee of 2%, and a 20% performance bonus on positive returns. In comparison, a more traditional equity mutual fund will have a management expense ratio (MER) 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 tend to avoid those highly levered, “go-go” type hedge funds that look to post outsized returns, because I believe they tend to take on significant bets that will pay off handsomely if they are right, but lose if they don’t.

A place for active management

I am also a fan of active management, particularly when you get managers who are truly active. Unfortunately, finding a great hedge fund or a great active manager is often more difficult than it should be. In many cases in the hedge space, it can be difficult to really understand their process, and how they manage money. And in other cases, we get long-only managers moving into the hedge space, and find out it’s more difficult than they thought. Frequently, we get substandard performance, and pay 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? In my opinion, no. I believe there can be a place for active investing, but it takes some legwork to find the right managers.

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.

Looking beyond costs

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 with the market.

So, does Mr. Buffett’s winning this bet mean all hedge funds and actively-managed funds should be avoided? Absolutely not! However, poorly managed funds, of any stripe, should be. 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 have the potential to be repeated.

Cost matters, but it is only one factor, and 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.

Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc., a consulting firm specializing in providing research and due diligence on a variety of investment products. He is also the publisher of Dave Paterson’s Top Funds Report, offering regular commentary and in-depth analysis of Canada’s top investment funds. He uses a unique analytical approach to identify funds with strong, risk-adjusted returns, and regularly publishes his insights and analyses in Fund Library.

Notes and Disclaimer

© 2017 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. No guarantee of performance is made or implied. This article is for information purposes only and is not intended as personalized investment advice.

 
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