Why Buffett Won His Bet Against Hedge Funds

by: Sami J. Karam

The hedge fund portfolio was leading for the first four years.

The Fed's intervention boosted the S&P 500 and expanded P/E multiples.

The story is not complete until the Fed's balance sheet returns to normal.

There is a place for hedge funds with strong management teams.

QE had a lot to do with it.

Active fund manager billionaires Warren Buffett and Charlie Munger have been critical of active fund manager millionaires for their very high fees and chronic underperformance. It is not unusual for the ultra wealthy to trash the merely wealthy for their avarice. After all, ultra wealth is so rare that it can be seen as an act of God, whereas mere wealth is the product of human toil and vanity, arduous and earthly.

Buffett and Munger are all-in on their recommendation that investors should dump active strategies and instead invest in passive indexed mutual funds or ETFs that simply mimic the S&P 500 (NYSEARCA:SPY). Although this is a popular line among many seasoned investors, it has been getting long in the tooth and has turned what was once a good idea into a crowded trade, with hundreds of billions of dollars shifting from active to passive.

In our view, Buffett's advice represents last year's thinking. This year's thinking, we argued previously, should be that passive funds are merely free-riding active funds - and that, past a certain market share, passive strategies will bite investors as badly or worse than active ones.

Of course, the current Buffett slam is greatly assisted by his triumph in his long-standing bet with Ted Seides (formerly of Protégé Partners, now at Hidden Brook Investments). The bet entered nearly ten years ago had Buffett on one side with the S&P 500 and Seides on the other side with his choice of a portfolio of hedge funds. Seides judged correctly in late 2007 that the market was due for a correction and he believed that his portfolio would outperform the index after ten years. Buffett wagered that the S&P 500 would do better.

Seides recently conceded that he had lost. Based on the numbers, that is indeed a fact. Yet Seides seems too generous and deferential in his appraisal of what happened. True, the S&P 500 trounced the portfolio of hedge funds, seemingly vindicating Buffett's premise that hedge funds are a waste of money easily beaten by a passive strategy.

But the bigger point is that Buffett had on his side the intervention of the Federal Reserve on an unprecedented scale. In fact, as shown in the table below, Seides' portfolio was leading through the end of 2011 but then fell behind quickly as would a fairly-matched tennis player whose opponent is unexpectedly joined by Roger Federer in the second set.

It will be remembered that the S&P 500 was bouncing back in 2009 and 2010 from the 2008 crash but that 2011 and early 2012 were decidedly wobbly. Seides' portfolio was leading throughout this period (in yellow in the chart) mainly because his hedge funds lost less money than the index in 2008. But then the Fed introduced QE3, also dubbed QE-infinity, in late 2012, and the index soared in 2013 and 2014, easily outperforming the hedge fund portfolio. The rise was so fast and powerful that any hedged strategy was bound to underperform the index.

Note in the chart below the large increase in Federal Reserve assets from $2.9 trillion in December 2012 to $4.5 trillion in December 2014, a 55% increase that coincides with most of Seides' underperformance. Of course, without QE1 and QE2 that preceded QE3, it is possible that the hedge fund portfolio would have stayed ahead by a significant margin from 2008 onward.

As a result of Fed intervention, the S&P 500 averaged an annual return of 15% in the period 2012-2016, well above its historical trend and despite the fact that the economy was growing at a tepid pace. In those same five years, the P/E ratio of the index expanded from 15 to over 25, a level rarely reached in the past 130 years and one that can only be explained by the Fed's exceedingly easy money policy. Both the performance outlier and the multiple expansion suggest an unexpected evolution that worked against Seides' hedge fund portfolio and in favor of Buffett's passive fund.

Few strategists would dispute the notion that the S&P 500 was greatly helped by this quantitative easing. The question then is whether hedge fund managers should have anticipated the Fed action and invested accordingly. This is an unfair burden to place on active managers, given the unprecedented quality of QE and the fact that central bank intervention has not always succeeded in delivering strong market performance, as evidenced for example by the 2000-02 period in the US.

Note parenthetically that Buffett's incredible record of success over several decades has rested in part on his near unflinching bet on large powerful US institutions, not only Coca-Cola (NYSE:KO), McDonald's (NYSE:MCD), Wells Fargo (NYSE:WFC) and American Express (NYSE:AXP), but also the Federal Reserve, the Treasury, the US dollar, the stock market, and even Wall Street though he may not like to think so. We wrote previously that Buffett's legendary optimism and confidence can be explained by the time and place of his birth.

In fact, we may legitimately wonder whether the Federal Reserve's actions, well-intentioned as they may be, cannot be blamed for the chronic underperformance of even the strongest active managers vs. passive indices.

Because Fed intervention dampens or stimulates activity and also creates P/E multiple expansion and contraction in the markets, setting performance targets on an active portfolio is like trying to strike a bullet with a bullet. Monetary policy must be considered an inevitable feature of the investment landscape but unprecedented and untested Fed actions need not be if they look like rules being changed in the middle of the game.

None of this should be read as an unqualified endorsement of hedge funds over other strategies. When evaluating hedge funds, consider the following three measures:

1. Performance

In two previous articles (here and here), we made the case that there is a place for equity hedge funds that manage to 1) avoid losses in bear markets and 2) capture 75% of stock market gains in bull markets. Our analysis showed that such funds would have outperformed or underperformed the S&P 500 depending on the year of their launch. As shown in the table, a fund started in 1966 did consistently better than the S&P 500 while a fund launched in 1976 did worse due to the Nasdaq bubble. Indeed, it will be noted that most of the red cells in the table are related to that bubble; an event that is unlikely to repeat itself in the near term.

Hedge funds that can deliver this performance are rare and require strong investment teams. Most importantly, they require patient investors who are willing to stay put for an entire cycle instead of bailing after one or two years of mild underperformance. But to claim that no hedge fund can ever add value because of its high fees is simply not true.

2. Investor behavior

When comparing with the S&P 500, one should also be cognizant that the behavior of an index investor is different from that of a more active investor. As the investor adage goes, "if you are going to panic, panic early." Yet the passive investor, by definition passive, would be one of the last ones to panic in a market meltdown and is therefore more likely to sell near a bottom. Seides addressed this when he wrote:

Long-term returns only matter if we invest for the long term.

Studies of human behavior repeatedly point to the inability of investors to stay the course through tough times. The S&P 500 had a harrowing start to the bet in 2008. In October of that year, Warren publicly made a prescient market call, reminding us to be greedy when others were fearful.

The S&P 500 index fund fell 50 percent in the first 14 months of the bet. Many investors lacked Warren's unparalleled fortitude, and bailed out of the markets when the pain became too severe. An investor who panicked and only later re-entered the market would have found that his bank account at the end of the bet was a lot smaller than a hypothetical account in which he earned the index-fund returns for the whole period.

3. Motivation of offshore investors

A large percentage of hedge fund investors happen to be foreign entities or individuals placing money in offshore vehicles. Contrary to Buffett's premise therefore, they are probably insensitive to fees in the same way that they are insensitive to the vagaries of the real estate market when they buy luxury condominiums in New York, Miami or London. Their main purpose is not strong performance (though that would be nice too) but to park money outside of home jurisdictions that they view as potentially unfriendly to their financial standing.

At any rate, because the Fed still holds trillions of dollars of mortgage bonds on its balance sheet, the last line of this story has not yet been written. What will happen when the Fed resumes its rate hikes and when it starts to unload its bond holdings? Perhaps Seides should have asked for an extension of the bet to fifteen or twenty years, at the same time that he graciously conceded defeat at the ten-year mark.

Disclosure: I am/we are long SPY, MDY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.