Buffett: Hedge fund fees are a waste of money
In his annual letter to Berkshire Hathaway shareholders, released on February 25, Berkshire Hathaway CEO Warren Buffett, the “Oracle of Omaha”, lambasted hedge funds that charged outrageous fees although their funds have failed to generate a respectable return.
Below we investigate what Warren Buffett is unhappy about, whether his complaints are justified, and how the US media has responded.
Buffett’s hedge fund antipathy
In order to understand why Warren Buffett criticised hedge funds, we need to understand what he thinks about the current state of the US economy and the investment environment, as set out in his annual letter to shareholders.
As in previous years, Buffett displays strong faith in the US and its economy. As he writes, “Americans have combined human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law to deliver abundance beyond any dreams of our forefathers.” He thereby makes veiled criticism of the Trump administration, which is challenging the market principle and the rule of law, and suggests that the American market system will not be uprooted by the “reforms” of a single administration.
Whilst asserting that he has “made no commitment that Berkshire will hold any of its marketable securities forever,” Buffett confirms that there has been no change in the firm’s underlying investment policy to hold shares in blue chip companies – the creators of social infrastructure – for the long term, saying, “It is true that we own some stocks that I have no intention of selling for as far as the eye can see (and we’re talking 20/20 vision).”
He repeats his long-held opinion that passive investment – which targets a return in line with the market average – is well suited to retail investors. He says that Berkshire Hathaway’s investment strategy mirrors such a low-cost, simple index fund approach, and that this is a far better choice than other investment strategies.
Index fund returns top hedge fund returns
Buffett then praises Jack Bogle, founder of the Vanguard Group, a US investment giant that pioneered index investment, in the following terms: “In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.”
It is in this context that the criticism of hedge funds emerges. In the letter to shareholders, Buffett relates how in 2007 he entered into a bet with Protégé Partners (a fund that invests in hedge funds) that over a ten-year period passive investment would outperform the active investment favoured by hedge funds. Believing that an index fund charging only a token fee would outperform hedge funds over the coming ten years, he set up a US$1million position to buy an S&P 500 index fund and sell hedge funds. Buffett and Protégé agreed to give the profits of this wager to a charitable institution.
Protégé Partners, for their side of the bet, picked five funds-of-funds that had invested their money in hedge funds. At the end of 2016, with just a year to go until the ten-year life of the bet expires, Protégé has generated a return of US$220,000 after commission on a US$1 million capital investment, while Berkshire Hathaway has achieved a return of US$854,000. And not a single one of those five funds-of-funds has outperformed the S&P 500 index fund since 2007. As a result, Buffett is certain he will win the bet.
Buffett estimates that investors have wasted in aggregate US$100 billion in paying fees to high-cost, low-return hedge funds over the past decade. He, who has a fairly simple lifestyle, is severe about the rich investors, who he says suffer this waste of money because they put their money in these high-cost investments for no reason other than that they mistakenly think high fees will buy them something better.
But, Buffett does not omit to add that, “To get biblical (Ephesians 3:18), I know the height and the depth and the length and the breadth of the energy flowing from that simple four-letter word – fees – when it is spoken to Wall Street. And when that energy delivers value to Berkshire, I will cheerfully write a big check.”
The US media backs Buffett
The US media by and large supports Buffett’s stance. Bloomberg concludes that his message is catching on, flagging the fact that in 2016, passive strategies attracted US$504.8 billion in new money, while active managers saw US$340.1 billion in redemptions, according to data from Morningstar Inc., and noting that research by UK data source Preqin reveals that 66% of investors questioned expect returns from active funds to be lower than projected.
Influential US money manager Steve Wallman foresees that Buffett’s letter championing index investment is “going to have a massive ripple effect.”
Warren Buffett has no doubt that he will win his ten-year bet against hedge funds. And we anticipate that in his next annual letter to shareholders, in early 2018, he will make the case for passive investment in even stronger terms.