Michael Michaud's  Instablog

Michael Michaud
Send Message
Michael Michaud is the founder of Invest2Success.com (http://www.invest2success.com/) and the Invest2Success Blog (http://invest2success.blogspot.com/). He has been investing and trading in the financial markets since 1989. He founded Invest2Success.com to empower individual institutional... More
My company:
Invest2Success
My blog:
Invest2Success Blog
  • Warren Buffett's Bet On The Huddled Masses 0 comments
    Dec 20, 2013 9:00 PM

    Warren Buffett's Bet on the Huddled Masses by Morningstar Investment Research

    The Bus vs. the Private Jet

    Yesterday, The Wall Street Journal's Spencer Jakab reminded me of a wager that I had forgotten: the performance of the S&P 500 against that of five hedge funds of funds, or HFOFs. The bet occurred in late 2007, with hedge fund manager Protege Partners selecting five HFOFs to compete against Warren Buffett's selection of Vanguard 500 Index (MUTF:VFIAX) portfolio. On Dec. 31, 2018, the 10-year results will be tallied. The loser must pay $1 million to charity.

    At the time, Buffett's decision appeared odd. Hedge funds were regarded as one of the ways that the rich became richer. Index funds, in contrast, were a sound way of investing in mutual funds--but they were only mutual funds. How good could they be if anybody could own them?

    Indeed, hedge funds had thrashed the stock market over the previous 10 years. Hedge funds had profited nicely during the decade's seven feast years and had also finished in the black during the famine of 2000-02, when stocks were thrashed. Over that period, HFOFs had trailed hedge funds themselves because of the cost of their extra layer of fees, but they were still well ahead of the S&P 500. From 1998 through 2007, HFOFs had gained an average of 9% per year*, with the S&P 500 at 6%.

    *Stating the "average" hedge fund performance is always a tricky business, as hedge funds self-report their returns. As a result, one hedge fund database differs from another. The 9% figure is taken from Morningstar's database and includes funds that no longer report their returns as well as those that remain live.

    The timing was not good for the stock portfolio, either. The wager was made after five straight years of stock market gains, when stock multiples were high and housing prices were already on their way down.

    One year into the bet, Buffett's selection was far behind. Stocks plunged, and Vanguard 500 Index plummeted along with them. Although HFOFs did not dodge the 2008 downturn as successfully as they had dodged the technology-stock sell-off a few years previously, their 18% calendar-year loss was less than half that of the Vanguard 500 Index portfolio. HFOFs were off to a large early lead.

    That bulge has now disappeared, and then some. The size of Vanguard 500 Index's lead is unknown because Protege has not released the names of the five HFOFs. However, the parties did state at the end of last year, when the bet was five years old and thus at the halfway point, that Protege's HFOFs had been virtually flat for the period. The S&P 500, in contrast, was up 8% cumulatively. With the S&P 500 rising another 29% this year, and most HFOFs treading water once again, the index fund's margin has become quite large. It's likely that Buffett's portfolio is now 30 percentage points ahead of the competition.

    There are three reasons for Buffett's relative success.

    First, as mentioned, the stock bull market returned. This is only a partial explanation because, although stocks have been exceptionally strong since early 2009, they have enjoyed only average returns over the six-year period covered by the wager. The Vanguard 500 Index portfolio didn't end up being hurt by the timing of the bet--but it hasn't significantly been helped, either.

    Second, hedge funds behaved differently back when the wager began. Until that time, as mentioned earlier, hedge funds had participated well when stocks rose and had protected well when they fell. Since that time, it's been something of the opposite. Hedge funds absorbed about half the downturn in 2008, yet have failed to enjoy half the gains during the rebound.

    Third, HFOFs have been particularly weak. HFOFs have never followed through on their promise of justifying their extra layer of fees. In exchange for an extra 1% per year of management fee (and often also a performance fee), HFOFs are supposed to garner higher gross returns by identifying particularly skilled managers, using its research resources to detect and avoid frauds, and by having the clout to get access to the elite hedge funds that will not otherwise take new monies. Historically, they have not delivered on the promise. But the performance gap in recent years has widened, to the point where HFOFs now appear to be trailing underlying hedge funds in both net and gross performance.

    In hindsight, this is what Buffett saw in 2007.

    1) Hedge funds had changed for the worse.

    Had the industry remained small and unknown, Buffett might well have refrained from the wager. However, with monies flowing into hedge funds pushing the industry's assets past the $2 trillion mark by the middle of last decade, hedge fund managers were in a bind. They could invest as they always had done, meaning that too much money would now be placed into too few trades. Or they could change by seeking less obviously profitable trades. Either way, they faced a problem.

    2) The cost advantage of the index fund remained intact.

    With HFOF fees running north of 3% annually (and potentially far north of 3% because of performance fees), hedge fund managers would need to get a lot of things right to overcome the ongoing cost disadvantage. It is possible that they could overcome point number one and get those things right, even with the burden of their swollen asset bases. But possible is not how to bet, not when the offered odds are even.

    Click the Links Below to Review Value Investing Advisory Services

    Morningstar Dividend Investor

    Dividend Paying Stocks Generate Real Cash and Build Wealth

    Value Stocks for Non-Billionaires

    The Very Timely Profit Power of Selected Value Stocks

    Value Engine

    Stock and Industry Analysis Reports Daily Technical Portfolio

Back To Michael Michaud's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.