Buffett Misses In Hedge Fund Fees Comment

Who am I to question the Great One? He’s produced 21% CAGR for 40 years. But I have to push back a little on Buffett’s entertaining, but somewhat misleading salt-of-the-earth populism.

It certainly sells tickets at the Qwest centre, but it’s an unhelpful contribution to the important debate over investment management fees.

In fairness, Buffett is one of then world’s most successful producers of alpha - beating the S&P500 by an average of 10%p.a. over the past 4 decades. But he takes his usual swipe at the “2-and-20 crowd” in his recently released 2006 investment letter. We commend his implicit emphasis on alpha as the raison d’etre for fees, but he is too quick to assume hedge funds simply deliver beta. Here’s an excerpt:

A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive this bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee.

Buffett says the “2-and-20 crowd” is paid two percent of your principle - as if traditional (mutual fund or investment advisory) fees are paid out of something other than principle(?). This linguistic acrobatics reveals an obvious bias that calls into question his objectivity on the issue.

What Buffett is missing is the fact that the “2-and-20 crowd” (a.k.a. “hedge funds”) tends to focus on alpha generation, not on riding the “rising tide” of market beta. We couldn’t agree more that a long-only large cap conservative strategy with a 2 and 20 fee would be a total rip-off. And let’s face it, a lot of these “hedge funds” do exist.

But let’s assume for a moment that a hedge fund produces true alpha for its 2 and 20 fee and compare that hedge fund to Berkshire Hathaway’s own historical results (contained in the letter). Here are Berkshire Hathaway’s annual results vs. the S&P 500 (1965-2006, dividends re-invested):

As we can see, Berkshire Hathaway has an alpha of over 16% per annum since 1965 - truly outstanding. But as Buffett himself states in the letter, his investment style was different in the “early years”. So let’s look at the last 20 years of returns vs. the S&P 500.

Still an amazing alpha (almost 11% per annum). But Berkshire’s trailing 20 year beta is over 0.72. If, twenty years ago, we had invested 72% of our assets in the S&P 500 and 28% in an all-alpha hedge fund, we would have received a contribution from beta of:

…and a contribution from alpha of:

We would have paid a very low fee for the beta, but what about that alpha? Well, if Berkshire Hathaway was a true mutual fund, we would have paid it about 1.5%p.a. in management fees. But with roughly three quarters of the fund being comprised of cheap, passive investments with a cost that is essentially zero, then the cost of the active portion (diagram immediately above) would be 1.5%/(1-0.72) or 5.3% per annum. And unlike “2 and 20″ funds, this 5.3% wouldn’t go down when performance headed south.

That’s a high fee for sure. However, Buffett is entitled to claim that it’s well worth it. As a stand-alone investment, that active portion has an average return of approximately 38.5% (10.79%/[1-0.72]) and a standard deviation of 34.5% after fees*.

Berkshire Hathaway (BRK.A) has achieved mythological status because a) it has produced a ton of alpha, and b) it has a negligible management fee . But as we can see, it’s actually Berkshire Hathaway that is more likely to benefit from a “rising tide” than the “2-and-20 crowd”. And that’s exactly why most long only funds should have a lower management fee.

Don’t get me wrong, I like Warren Buffett just as much as the next guy. But all of us - Buffett included - should probably avoid blanket statements of condemnation about fees when reality is so much more complex.

*What’s important here isn’t the absolute value of these numbers, but their ratio (Sharpe ratio) which is about 1.0 - very good indeed. Interested readers should note that the “active portion” would be closer to 50%, not 28% under the added constraint that the active portion have the same standard deviation as the market (thus reducing the effective fee). But the fact remains that fees for active management (ostensibly, the reason for the fee in the first place) are higher than those posted by mutual (and even hedge-) funds. For much more on this type of analysis, see Ross Miller’s seminal paper on the topic.

Comments

[Nick Mulcahy]

The key phrase in this article is "But let’s assume for a moment that a hedge fund produces true alpha for its 2 and 20 fee...".

As Wittgenstein wrote in a different context: "If you assume that, I'll grant you all the rest!".

[Amit Chokshi]

Buffett ran a partnership before BRK and got paid 25% after clearing the 6% hurdle rate. I admire him but find his annual letters to be much better for those with a passing interest in investing. Does your analysis implicity state that ou think investors are better off paying 2 and 20% for a beta neutral long/short hedge fund to reduce volatility? What if investors are in a 2 and 20% long/short fund where the short and long book are not integrated and both the short and long book go in the wrong direction? And how is a 2 and 20% long-only portfolio a ripoff? Most hedge funds are absolute return vehicles and running a matching short portfolio is not the only risk mitigation tool. How would you rate the long-term returns of Mohnish Pabrai, Tom Brown, Lampert, etc. who do not run short books?

[kurt walter]

Too many hedge funds charging too much for poor performance. The shake out will eliminate thousands of hedge funds in the future. Everybody and his brother wants to run a hedge fund. Those "genius" investors in Long Term Capital are even back for more. Amazing anyone would give them a dime.

[SVF]

First of all, the fee for the market exposure, ie beta, should be about 8-9 bps if you look at ETF index funds, which is obviously a ripoff given that institutions that negotiate can buy it for 2-3bps, which is itself a ripoff since there is 8-13bps in securities lending revenue in there.

Second, managers should not be paid a performance fee for putting the money in a bank and getting libor. So all the hedgefund should have a hurdle at least similar to risk free investment. The result is that Buffett's original fee schedule of 25% of all above 6% is actually a fair fee schedule. If as a hedgefund picker you get 2/3 of your picks correct and 1/3 wrong, 25% indicates that the profits above LIBOR is equally split 50/50 between the hedge fund manager and the buyer (if underperformance and outperformance is same magnitude from LIBOR). Fair enough.

So the problem is the 2% and the lack of a hurdle, not the 20%.