Defining a Top Fund Manager

 |  Includes: BRK.A, BRK.B
by: Veryan Allen

Who's better? Warren Buffett or George Soros? Why invest with people who are not the world's best at what they do? Warren and George searched for successors from hedge funds and all their liquid net worth is in absolute return. If you want the best sportspeople you look in major leagues not minors, and where are you likely to find the best portfolio managers? George and Warren's talents were proven long ago so there was plenty of time to invest. Their successes as hedge fund managers have had major philanthropic benefits for society and many very satisfied clients.

Those claiming Warren is not a hedge fund manager seem unaware that arbitrage, leverage, derivatives, event-driven, special situations and macro trading added much to returns and he shorted cocoa for a capital structure arb as far back as 1954. Neither has a PhD or CFA but both Warren and George have exceptional quantitative skills. I have never seen a good trader that doesn't, even if they run "discretionary" styles. Over 41 years George has turned $1,000 into $14 million after fees, Warren to $3 million in his ETF hedge fund. Berkshire Hathaway (NYSE:BRK.A) charges less fees for high skill than "low cost" SPY or VFINX. Below is net growth of $1,000 since 1969 from George and team, Warren and team versus the long only "passive" S&P 500 team, who hardly register.

George's track record is better but Warren is richer. Why? The miracle of POSITIVE compounding on larger AUM. Warren set up his hedge fund in 1957 but George didn't set up his firm until 1969. Warren is from Omaha while Dzjchdzhe Shorash is from Budapest, a city more fraught by WW2. Warren got into currency trading and global diversification about ten years ago while George bought Japanese and other countries' stocks in the 1950s. George's outperformance is due to deeper international knowledge and his philosophy, REFLEXIVITY, is still ignored by the crowd, despite its success. Value investing is widely followed so more imitated than reflexivity investing.

Warren ran the absolute return fund from 1957-1969 and has since implemented his strategies via Berkshire Hathaway. He first bought BRK.A shares in 1962 at $7.60 and now it's $120,000 for a 22% CAGR. But the Buffett Partnership did better with all 13 years positive. With a 25% incentive fee on 6% hurdle, gross returns of 29.5% were net 23.8% to investors. What if, instead of "retiring" in 1970, Warren had continued the partnership and that performance had persisted? Investing $1,000 in 1957 would now be $100 million. Fees that Warren might have been "paid" for turning $1,000 into $100 million would be $1 billion. That's fine by me since it's $99.9 million more than wasting time in a cheap unskilled fund. Here is Warren's 54 year track record.

Famous economists say Warren is just a lucky outlier but some people DID seed him in 1957. The S&P 500 also began in 1957 but has performed poorly by comparison - $1,000 would now be about $100,000, obviously a huge opportunity cost. Investing with an absolute return objective using competitive edges and outside the box skills has existed for centuries. Relative return is a fad. Passive indexing is even newer. The trouble with owning dartboards is that you get the treble 20 and bullseye but you also tie up precious capital in many 1s and 2s. With proper analysis, average hedge funds can be avoided just like average stocks. I prefer to look for the Phil Taylor of finance. How many darts must you throw to show skill? George and Warren hit lots of treble 20s.

Some hedge funds shut down due to SUCCESS. Warren closed his fund in 1969 despite a strong track record as Stanley Druckenmiller did recently with Duquesne. The Buffett Partnership was set up when the Graham-Newman hedge fund closed, around long before AW Jones' "first" hedge fund. Warren wants to be judged on book value but you can't eat book value and I judge by what investors really receive. Partnerships are marked at NAV but the switch to BRK.A subjected clients to the higher risk of public markets. In 2008 BRK.A book value dropped -9.6% but shareholders lost -31.8%, while George made money that year. While the stock has returned more than book value due to the premium valuation, volatility has been high. Warren's TRUE Sharpe ratio is much lower than the book value "Sharpe ratio". It drops from 1.4 to the 0.6 actually delivered.

George and Warren were born in August 1930 and have long track records of alpha generation from low frequency trading in various fund structures. Double Eagle -> Quantum, Buffett Partnership -> Berkshire Hathaway. Both have "retired" before and been searching for "successors" for a long time. George has been hiring "replacements" since 1981 and the extent of his fund management involvement has fluctuated since, though never without close knowledge of-- and implied agreement with-- the portfolio. For every Li Lu or Todd Combs there was a Jim Marquez or Stanley Druckenmiller. No man is an island and both sought out strong colleagues and talented employees from early on. Jim Rogers and Charlie Munger added a lot. Accredited investors -anyone with $80 - can access Warren and Charlie's talents through BRK.B, a listed closed-end hedge fund.

Those "outrageous" fees? George charged 1% and 20%, no hurdle, while Warren charged 0% and 25% on 6% hurdle, then offered his money management skills for FREE in return for permanent, leveraged capital. But you would have done much better going with George Soros in 1969 and paying him those "high" fees than you would with BRK.A. I am happy for people to be compensated well for delivering what I need, ABSOLUTE ALPHA, from their RARE abilities. If someone turns $1,000 into $100 million from skill not luck or riding the market, they deserve $1 billion. Especially when interests are aligned with clients by them being the largest investor in the fund.

This assumes fees compound without the manager needing any money to eat, live, pay employees, run the business etc. which of course they do. In recent years, with investor demands for larger teams, deep benches and operational infrastructure, fixed costs for hedge funds have risen to the model 2 and 20. A few people, a computer and a phone would not get pension fund money today. Sad to see an Omaha pension in $600 million deficit when they could so easily have had a local hedge fund run by Warren Buffett get them into surplus. Avoiding "high" fees for alpha is like saying to a Porsche dealer you will only pay $100 for a new car because that is what the raw materials cost, or that Shakespeare was just a lucky fool who "randomly" chose words from the dictionary.

I am writing this on Apple (NASDAQ:AAPL) hardware using Microsoft (NASDAQ:MSFT) software uploaded to a service owned by Google (NASDAQ:GOOG). Using those products may further enrich several people who are already billionaires. Does it matter? Would Warren and George have bothered taking outside money if they hadn't been incentivized to do so and perform? High absolute returns are helpful and I'll take $100 million over $100,000 every time. I assume you would too. So what if the fund manager becomes a billionaire? They deserve it for the essential entrepreneurial service they offer. If clients get rich, it is fine by me if the manager gets richer. Plenty of "cheap" funds available but at what performance?

It's skill that adds value. No alpha, no incentive fee. George's partnership fees were lower than Warren's for gross returns above 25%. Since George and Warren's gross performance was in excess of 25%, George's deal was actually cheaper. Jim Simons and team outperformed both for the past 20 years with much higher fees and the net returns were superior. The technological and personnel infrastructure requirements for high frequency strategies cost far more than low frequency trading. If you don't like the fees, don't invest in hedge funds. Capacity for a good strategy is limited and demand exceeds the supply of alpha. You CAN spend absolute returns. Expensive and dangerous waiting to find out WHETHER beta might one day deliver.

It is hard to prove a theory for all cases but to DISPROVE it a single counterexample suffices. Warren, George, Jim and many others have destroyed efficient market hypotheses, random walk assumptions and the mistaken idea that long term policy asset allocation drives portfolio returns. Brinson BHB et al have cost too many investors too much money. In truth people want 100% of their capital in attractive opportunities. George and Warren's alpha capture from security selection and market timing worked better than static beta bets. No-one says it's easy but if you are smart and work hard enough, it is possible. Such investment teams CAN be identified at an early stage and charge whatever hedge fund fees their clients are prepared to pay.

No-one is forced to invest in hedge funds. Investors are free to make do with passive beta and relative return if they so choose. Some academic outliers even say alpha is due to luck! For those "surprised" by the Euro crisis in Spain, Ireland, Greece, Belgium, Portugal etc., George saw the dangers long ago. Yet macroeconomic "stability" maven Robert Mundell keeps his Nobel Prize...for now. Optimum currency areas aren't optimal so give it to George. If you flip a coin 10 times and get 8 heads it might be a fluke but NOT if you flip 100,000 coins and get 80,000 heads. Warren and George have flipped too many coins for their AFTER FEE returns to be considered luck. They made their clients rich, deservedly got richer themselves and are giving that wealth away for the social benefit of the world. A rare financial win / win / win.

Disclosure: No positions