Hedge Funds and the Early Buffett Partnership

 |  Includes: DIA, QQQ, SPY
by: Joe Ponzio

On a number of occasions, we've discussed Buffett's early partnerships—their performance, his investment style, or some other aspect of 1950s and 1960s Buffett. One of the great things about Buffett was that Warren put his money where his mouth was, unlike today's mutual fund manager that generally puts your money where his/her mouth is.

If you are considering starting a "hedge" fund, you might want to consider an Early Buffett Partnership structure.

What Is a Hedge Fund?

Mutual funds and hedge funds are very similar. An investor puts $10,000 into a mutual fund or hedge fund, and the manager uses that $10,000—along with the rest of the fund's capital—to buy and sell securities.

Though often shrouded in mystery, hedge funds are pretty easy to understand. A mutual fund has to register with the Securities and Exchange Commission, a hedge fund does not. Why? Hedge funds are exempt from registration because they generally operate under one of two exemptions provided by the Investment Company Act of 1940:

So...a hedge fund is little more than an unregistered mutual fund.

Buffett Ran a Hedge Fund

In his early days of managing money, Buffett ran a hedge fund. His early partnerships were not registered with the SEC, allowing him to operate with very low overhead and a considerable amount of freedom.

At a minimum, registered mutual funds need boards of directors, exchange registration, audited financials...the list is long and expensive. Though hedge funds today are often seen as highfalutin, expensive operations, a hedge fund can operate for just a few hundred bucks a year.

Take, for example, Buffett's early partnerships. He ran them from his house for many years. Save the annual audit he opted to do for his investors, the cost to run the Buffett partnerships was little more than the cost of the transactions and Buffett's performance fee.

Aren't Hedge Funds Aggressive?

The term "hedge fund" is actually a gross misnomer. Today, any unregistered mutual fund is termed a "hedge" fund; but, a hedge fund does not have to be aggressive. In fact, I can start a hedge fund tomorrow and invest entirely in US treasuries; or, I can invest entirely in GM...on margin.

Hedge funds are getting beat up in today's news, many for good reason. But, not all hedge funds are aggressive, super-short, kill-the-markets funds.

The "Buffett" Hedge Fund Versus Today's Hedge Fund

Today's hedge fund typically charges a 2/20 fee—2% a year management fee and 20% of the profits above a certain level. Interestingly enough, I had a conversation with a hedge fund manager last week. I learned that many funds pay all of their bills, salaries, and bonuses off the 2% management fee. The 20% performance fee is merely gravy; so, there is no real incentive to perform short of keeping your investors.

Buffett went a different route.

In his early partnerships, Buffett decided to charge a 0/25 fee—no management fee, and 25% of profits above a certain level. (He had a few variations of this based on the certain level; but, he never charged a management fee. He was performance-only.)

For Buffett to pay his bills, pay salaries to his staff, or pay bonuses, his investors had to earn money. If they didn't make money, Buffett had to foot the bill out of his own savings. It was one heck of an incentive to protect and perform.

Putting His Money Where His Mouth Was

If you agreed with Buffett's investment philosophy, you'd be nuts not to invest with him. Buffett was offering a sweet deal: As an investor, you wouldn't pay Buffett a dime unless you were earning more than 6% on an annualized basis (the "hurdle rate"). Beyond that, you would split each dollar of profits: $0.75 for you, $0.25 for Buffett.

So, if you earned 5% or if you lost 10%, Buffett made nothing. If you earned 8%, Buffett made 0.5% and you took home 7.5%. If you earned 30%, you took home 24% and Buffett took home 6%. Not to Pick on American funds, but the Investment

Investment Company of America

Company of America is one of the largest mutual funds around. Over the past ten years, The Investment Company of America has returned, on average, 3.10% to investors—less if they paid a commission to buy it. From where it stood on October 31, 2008 and if Buffett were at the helm, it would have to grow 32% immediately before Buffett could even think about earning money.

But, the ICA is not an Early Buffett Partnership; so, the investment manager will take home about $140 million this year. American Funds will collect $200 to $300 million in distribution fees, plus another $50 million or so for postage, reports, "administrative" services and the likes.

The Hurdle, the Fee and the High Water Mark

No...it's not the bedtime story I tell my kids. Buffett's early partnerships had three components you should be aware of if you are looking for a hedge fund or thinking of starting your own:

  • Fees. Buffett charged no management fee, just a performance fee based on profits. It was a 0/25 hedge fund.
  • Hurdle Rate. Before Buffett could earn his performance fee, investors had to earn more than 6% for the year.
  • High Water Mark. If investors were not earning 6% annualized, Buffett couldn't charge a performance fee no matter how stellar a particular year was. Example: If Buffett lost 50% his first year, and then gained 80% his second, investors would have an annualized return of (5%). Even though his second year was stellar, Buffett could not charge a performance fee because his investors would have earned less than 6% annualized.