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
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
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
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.
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