"In Berkshire’s 2005 annual report, I argued that active investment
management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund. ”
He then goes on to show how that's been true, and that a standard index fund outperforms almost every hedge funds even before extra fees to the hedge funds are taken into account.
It's not the first time this has been pointed out, and it suggests that for non-multimillionaires, an index fund is always the most rational choice.
You get close to the return you'd get by investing in real estate, with the added benefit of index funds being much more easily liquifiable.
"My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade."
I would argue that index funds make the most sense for most millionaires these days, too. For the most part, if a hedge fund is actually worth investing in (and there are quite a few), only institutions will have the capital to play.
Actually having a giant amount of money to throw at a hedge fund is counterproductive. In order to invest all that money, a greater number of investments will need to be made. And the more investments one makes, the more likely it is for them to revert to the mean, performance-wise.
It's a simplification, but if a hedge fund manager finds a fantastic investment for $100mn, but they have $100bn to invest, they have to be able to repeat that feat over and over and over and over.
Yes I'm aware of that, but it doesn't change the reality that hedge funds have an incentive to have more money from fewer investors, even if they have to be careful not to take on too much money overall.
Which is how you end up with Access Funds who charge fees to put money into other hedge funds which they got capital into early and performed well. So now to get into a very successful fund you're paying two sets of fees and praying that they continue to outperform.
Hedge funds are at best going to net break even as an industry after fees, quite probably negative. So to look at "Funds of funds" and say they're a good idea is pretty mind boggling.
> if a hedge fund is actually worth investing in (and there are quite a few)
Apparently it is hard to come up with a collection of 5 of them that would beat the S&P 500 over 10 years. At least Buffett had a hard time finding counterparties for a bet.
RenTec, D.E. Shaw, Baupost, Bridgewater, Farallon, off the top of my head. There are others. I agree that it's hard to find firms that beat the market over long terms but it's not quite that difficult.
Much like other very difficult but not impossible things in life, it is very difficult but not impossible to beat the market for long periods of time. It's fair to say that most people, millionaires included, should go with index funds. But that doesn't mean it's hard to come up with funds that beat the market. They just aren't really available to people without a very high net worth.
Unfortunately the conversation about hedge funds has been dominated by binary thinking, especially since Buffett's wager was publicized. The pendulum has swung so far to the other side that there's not a whole lot of fair discussion about the utility of hedge funds.
Are you willing to bet $1,000 that those funds will, in aggregate, beat VTSMX over the next 10 years?
It's easy to pick the winners in hindsight. Buffett put $1mm on a bet that it's hard to do it beforehand. If Protege partners couldn't do it with $1mm on the line, what makes you so convinced that you can?
It's a little reductive to use "past performance is not an indication of future gains" as an argument. If you extrapolate that with the premises that I am using (namely, that it is possible to intentionally and consistently beat the market), there is no reason to have faith in the continued investment in anything, private or public, because you cannot use any past measure of success as guidance. But I don't care about the success in of itself, I care about the cause of that success, and intrinsically I believe there is a cause.
Facebook has done well since its IPO. But since we're throwing out its past performance entirely, we shouldn't consider it a sound investment. Venture capitalists shouldn't have faith in Uber or Snapchat, because its past performance as a private company means nothing going forward. Real estate is not a sound investment because eventually there will be another market correction. And so on and so forth.
Except there are sound arguments for investing in each of those examples (please don't nitpick them specifically...) because people naturally view their respective success as a function of purposeful action. I view certain hedge funds as possessing the same capability for success.
Ultimately, entropy consumes every existing phenomenon we can observe. What we define as "consistent success" is only coherent over slices of time for anything, not just the ability to forecast the market. The only reason why we continue to invest in anything is because we believe that someone at the helm of past success can continue to pull it off in the future. Every streak must necessarily come to an end, whether it's competing as an elite athlete or being the dominant technology company or forecasting market movements.
So yes, I'd absolutely take that bet. I don't believe in EMH; I believe that past success for firms like those has been caused by skill and strategy, which is repeatable until fundamental things change (industries evolve, markets evolve, successful managers retire, etc). I definitely believe that firms like Renaissance Technologies will continue to print money in the future because they have a profitable methodology for doing so, unless something changes. Because I do not believe the success is due to chance, this wager becomes more a question of whether or not I believe the skilled management of these firms will change in the near future or whether the market itself will fundamentally make their strategies untenable. For most of them, I'm confident in another ten years of superlative performance.
All successful investing begins with observing, modeling and capitalizing on market inefficiencies. You can do this with real estate, business ownership, securities, etc. It is clear to me that there are hedge fund managers who are playing an entirely different game than the unprofitable ones the media fixates on. They are similar only in name, but it's like the difference between counting cards and gambling. These are managers who can identify, through their own insight or the aggregate insight of their firms, inefficiencies esoteric enough that they are extremely difficult to find, but useful enough that they can be profitably traded on.
EDIT: I forgot you asked me a specific question...the reason why I feel confident taking on this bet when Protege Partners, LLC is losing is because I'm choosing a small, specific subset of the hedge fund industry that I believe in for the reasons explained above. In contrast, Buffett and Protege's bet is over a basket of funds, a "portfolio of funds of hedge funds." I am not arguing with you that most of the hedge fund industry is crap, just as I wouldn't argue that most people who start tech companies fail. I'm betting on the outliers.
If anyone can just log onto Long Bets and do this I'm happy to take the bet with you immediately.
> It's a little reductive to use "past performance is not an indication of future gains" as an argument. If you extrapolate that with the premises that I am using (namely, that it is possible to intentionally and consistently beat the market), there is no reason to have faith in the continued investment in anything, private or public, because you cannot use any past measure of success as guidance.
No, the point is that any of these outliers that beat the market will, given time, revert back to the mean. Given this, you are simply wasting money on fees for actively-traded funds.
> Facebook has done well since its IPO. But since we're throwing out its past performance entirely, we shouldn't consider it a sound investment.
The market has already factored this information into the price of Facebook. Facebook, the company, may continue to perform well. But if everyone believes this, the stock will be trading at a premium compared to what its current situation looks like.
Facebook, or any other company, could have ten years of record-breaking quarters and the stock not move a dime if the market already assumed there was a significant likelihood that this would happen. It could even decrease if these record-breaking quarters fell short of what the market was expecting.
> I don't believe in EMH; I believe that past success for firms like those has been caused by skill and strategy…
Then invest in these funds and make a killing.
Funnily enough, few of the people who claim to disbelieve in the efficient-market hypothesis are billionaires.
> …I feel confident taking on this bet when Protege Partners Protege Partners, LLC is losing is because I'm choosing a small, specific subset of the hedge fund industry that I believe in for the reasons explained above. In contrast, Buffett and Protege's bet is over a basket of funds, a "portfolio of funds of hedge funds."
That "portfolio of funds of hedge funds" was chosen by Protege Partners exactly the way that you are doing. They picked a portfolio of hedge funds they believed were most likely to succeed over the long haul, and they are losing. Badly.
At least as far as the bet goes. I suspect they've made more than the million dollars lost in the bet by marketing themselves as being confident enough in their picks to make such a bet against Buffett.
In a roundabout way I do invest in hedge funds as part of professional work. At the very least, I have a financial interest in certain funds' success because it will directly translate to my own financial success. (Anticipating a question - I do work in finance, not just the security consulting which is in my profile, and I cannot be more specific than that).
Per your parallel comment - can you define "measurable"? For example, can I just choose RenTec's Medallion and call it a day? How quickly does data about the fund's annual performance have to be available, and from which source preferably?
At this juncture it might just be easier for you to email me :)
Choose a measurable fund or a weighted set of them such that one can do an easy comparison of returns, net of fees and expenses, against VTSMX and I'll create the bet on longbets.
If you're trying to locate them after the fact it's quite easy, nothing hard about it at all. It's using skill to identify them before any given period that's hard. Plenty of people do in fact end up identifying them before any given period, but no more than would be predicted by chance, so it is quite hard to prove that anyone at all identifies outperformers using skill; it's laws of chance at work, even though many like to think they used skill (or like for you to believe they used skill, if they're trying to get you to pay them to manage your money).
It's easy to find funds that had great performance in the past. If anybody knows how to pick those that will perform in the future, they are keeping it a secret.
And you might not be able to invest directly in rentec, but their holdings are public [1]. So if they really had a good secret, it could be replicated.
Those are only their LONG holdings, and rentec isn't a long only fund. In addition, SEC disclosures lag behind and doesn't disclose at what price shares were acquired.
So by looking at their SEC disclosure forms you can see which investments would have made you money in the past, the only thing you now need is a time machine.
RenTec doesn't make money off "buy and hold." They're a quant firm that profits from small inefficiencies in the market, trading that with leverage. Their really good secret is that they have superior data sources, and superior modeling (lowering their risk to almost nothing).
That might be true, but you'd make your argument more credible if you cited Bloomberg (or anyone else, but BB is who ZeroHedge cites) rather than ZeroHedge, the InfoWars of finance.
> That might be true, but you'd make your argument more credible if you cited Bloomberg (or anyone else, but BB is who ZeroHedge cites)...
Your statement's not "credible." ZH didn't just cite Bloomberg. The ZH post also includes excerpts from the 93 page report (not included in the Bloomberg article) released by the US senate subcommittee, which was highly relevant.
Is anything in the ZH post false? Please add it to the discussion.
Next time, please comment on the substance of ideas and arguments instead of ad hominem attacks. It was one of the first searches that came back for the topic I was looking for. It added more context than a brief Bloomberg article.
Pointing out that a source isn't credible isn't an ad hominem attack --- or, in my case, even an attack at all. I'm broadly sold on the idea that Renaissance profits largely through tax loopholes.
Although the tax loopholes could increase their income by about 15%, it doesn't explain all of it. Being able to increase their leverage from 1:2 to 1:20 could account for it, but it would require covering loses.
If that's really all they did, it's basically a Ponzi scheme, because they would sometimes lose money.
Hedge funds make perfect sense for people who want to hedge their capital in specific ways. A hedge fund doesn't need to outperform the market to deliver tremendous value to their customers.
Secondly, every trade has a counterparty. So somebody necessarily has to be at the loser's end of every trade. For every investment fund that makes oversize profits another fund loses money. It all evens out. That doesn't mean it's entirely zero sum, though, because money still flows from bad businesses towards good businesses as a result. The incentives for professional money managers are also totally misaligned: funds performance is reported quarterly leading to a short term bias; fund managers get a bonus if they invest irresponsibly but get lucky; customers are unsophisticated so it's one big lemon market.
I agree that index funds make a lot of sense for non-millionaires (and single digit millionaires), but that's simply because it takes a lot of effort to beat the market even by a few percent so you need a lot of assets for it to be worthwhile.
> That doesn't mean it's entirely zero sum, though, because money still flows from bad businesses towards good businesses as a result.
Buffet's point is that it's negative-sum. A gambler might win today, but lose tomorrow, and his counterparty will get the opposite, but the house wins on every transaction. While the players churn, the market makers and rent seekers will drain the system of money, in aggregate.
You're reading it incorrectly. Buffett is making the claim that people have "waste[d] more than $100 billion over the past decade" looking for superior investment returns. That's his claim, no more. And I agree.
There wouldn't be a stock market if everybody just invests in a fortune 500 index fund. The benefit to society of a functioning stock market is way more than $10B/yr.
No, he isn't reading it incorrectly. Buffett is claiming that on aggregate, because of the fees, the passive investors will be better off than the active investors.
From page 23:
A lot of very smart people set out to do better than average in securities markets. Call them active investors.
Their opposites, passive investors, will by definition do about average. In aggregate their
positions will more or less approximate those of an index fund. Therefore, the balance of
the universe—the active investors—must do about average as well. However, these
investors will incur far greater costs. So, on balance, their aggregate results after these costs
will be worse than those of the passive investors.
Yes, but Buffett is not claiming that active investing (as opposed to passive index investing) is negative-sum in aggregate! That would be ludicrous, because Buffett is an active investor himself and the Buffett Annual Report is a long form sales letter to persuade people to buy more Berkshire shares.
Buffett, as an active investor, can outperform the market, while active investors as an aggregate might not. I fail to see any ludicrousness.
> Buffett Annual Report is a long form sales letter to persuade people to buy more Berkshire shares.
Nonsense. Buffett doesn't care one whit about people buying more Berkshire Hathaway shares. If anything, he wouldn't mind people selling shares and driving the price down to below 1.2 x book value, so he can buy them back at a discount.
If active investment were negative-sum in aggregate then society would be better off if there were no active investors at all and everybody would invest in passive index funds instead. Unfortunately you need active investors to keep the market honest, without active investors index funds wouldn't work!
Index funds are needed so investment funds don't overcharge their customers, and investment funds are needed to keep the market honest.
It makes sense for individuals (or institutions) to invest in index funds, but only up to a point. When too much money is stuck in passive index funds the active investors will easily outperform the market and the smart money will leave the index funds again.
The person I was responding to was drawing an analogy to a casino where the money just moves around and the institutions just skim every time money changes hands. That's negative sum. In contrast, society benefits when the stock market gives access to capital to well run companies and takes money away from poorly run companies. So the casino analogy doesn't work. Buffett understands that the stock market as a whole isn't zero sum (or negative sum), and that's true even if all investment firms in aggregate underperform the indexes.
Investing in the stock market is secondary to the actual investment into activities performed by the companies that constitute it.
Thus, investments decisions made within such companies are those that promote their growth (or not).
In this manner, without insider knowledge into the internal decisions those companies make, and thus the ability to judge the viability of their investments, investing in something other than a stock index is much riskier. But the stock market itself can still grow.
The distinction is that investing in "the market" is an arms length investment that occurs well after the good or bad investments that affect the profitability of individual companies have occurred.
I think you and your interlocutors are talking past each other. It's true (and fashionable to point out) that active investment is what makes price discovery, and thus the markets themselves, work. But that doesn't make it a good idea to invest in hedge funds or any other active investment vehicles. Just as Buffett describes earlier in the letter w/r/t the insurance business, active investors can compete the returns on effective price discovery down below the returns on passive investing.
Maybe over the long term the returns on active investing will simply go to prop traders.
Perhaps it is fashionable to point that out where you live, but common wisdom I hear is "everybody should just use index funds", without stopping to ask what would happen if everybody actually did.
Worldwide equities are 65 trillion or so. Can you have a functioning stock market if 1T of that is actively managed by prop traders and the remaining 64T is in passive index funds? I'm not so sure.
Now you're talking past me. It does not follow from the fact that active investment is necessary that people should invest with active investors. Again, fierce competition among active investors can --- and probably have --- created conditions where all the returns on active investing will go to (effectively) proprietary traders.
I don't think I'm talking past you -- your previous point was perfectly clear. You literally cannot have active investments if nobody invests with active investors or actively manages their funds themselves. This is tautological. So somebody has to invest with active investors, but Buffett is arguing it should be somebody else and not you.
If 99.99% of all assets are locked up in buy-and-hold passive index funds the prop traders can't do anything when a stock is mispriced because they can only trade with the handful of active investors that remain. With 65 trillion in equities a handful of prop traders can jump high and low all they want but the markets won't budge if nobody is buying or selling. The index managers on the other hand will be able to move markets with a keystroke, because whenever they decide that one stock in the index has to be replaced by another all the index fund money blindly follows.
You're now litigating the literal definition of a prop trading firm.
Nobody is arguing that you shouldn't start a prop trading firm. The argument is that you shouldn't invest in hedge funds, because passive investment funds outperform them. If you want to make money in active investment, join or form a prop firm.
The broader point would be, the market can probably function based on passive investment and inputs from prop firms, without retail and institutional investors ever needing to engage in active investment. That would also be compatible with the notion that active trading is in general unprofitable because the profit is so aggressively competed out of it.
I literally made this point earlier. I even used the word literally to indicate I meant it literally.
> Nobody is arguing that you shouldn't start a prop trading firm.
I disagree. People are absolutely arguing that nobody should start a prop firm because you can't beat the market. That the prop funds that succeed are just those that have gotten lucky in the short term. That everybody should put their money in index funds instead. I know you don't believe this, but it's a common belief for sure.
I think that if all retail investors and all institutional investors exclusively invest in passive funds the market will get out of whack. We're talking about all pension funds, university endowments, private trusts, all moving to index funds. All households together own about 80% of the stock market (direct + indirect ownership). Hedge funds another 4%. Prop trading firms probably less than 1%. There are over 3500 publicly listed US equities and another 10,000 OTC. Deep analysis on every equity is needed to determine if it is fairly valued; no way prop firms can take on this gargantuan task by themselves.
Not to mention that index funds are long-only. Very few hedge funds are. If almost everybody moved to index funds the long-only bias by itself could be disastrous.
Like I said, I wasn't say you were wrong, I was saying that you and your interlocutors were talking past each other. It can simultaneously be true that active investors can "beat the market" and that retail and institutional investors shouldn't invest in actively-managed funds.
The place I think we got hung up here is on the notion of "nobody investing in", because obviously a person who starts or joins a prop trading firm is in a sense investing in that firm.
It can be true, but my point is that it probably isn't true. And I've explained why I think this. You can look at passive investing as defecting in a large game of prisoner's dilemma (tragedy of the commons). With passive investing you enjoy the benefits of an efficient market without doing any analysis yourself (or paying for somebody else to do it on your behalf). So you can advise every individual to defect (because it's in their best interest) but if too many people defect the system breaks down.
So when you say "It can be true that [...] retail and institutional investors shouldn't invest in actively-managed funds", that can mean two totally opposite things, as hopefully you can now see. That's why we talk past each other. I also suspect there is a real disagreement about what the impact of index funds will be in the long term.
> Buffett Annual Report is a long form sales letter to persuade people to buy more Berkshire shares.
If you have read his past reports you will know that he wants his shareholders (he calls them partners) not to sell their shares. He published some numbers in the past as well where 90% of shareholders don't sell and he is very happy about that.
Suppose you're a business with a lot of positive cash flow, but you also have a lot of exposure to the USD-MXN exchange rate. Maybe you have factories in Mexico but sell to the US, it doesn't matter. In that case you can pay a hedge fund to hedge your money so that if the exchange rate collapses you make enough money on the stock market to compensate, so your business will survive until the exchange rate climbs back.
Most businesses have very high exposure to one section of the market, so wanting to hedge is natural. If your business makes toilet paper you have it easy because no matter what happens demand for your product won't collapse overnight. If you make cars then economic recessions are scary because new car sales will drop like a brick, and you need to hedge.
Most hedge funds have very little to do with the kind of hedging you describe.
If you had that kind of exposure to currency risks, you wouldn't go to a hedge fund. You can easily hedge that risk yourself with futures or options. If you wanted to pay somebody for it, you would go to your banker and he would do it for you for a fraction of the 2/20 fees charged by hedge funds.
The average banker has no idea how to hedge any serious amount of money, nor does the average banker understand what kind of hedging strategy is appropriate for a business. Nothing about hedging with futures or options is easy. Also, hedge funds don't charge 2/20 anymore like in the good old days.
Nonsense. Futures and options and how to use them to hedge exchange rate risks are covered in any good masters in finance (source: I have a masters in finance). You don't even need any advanced math (the ancient Greeks were using options to hedge their olive harvests).
The bank teller might not know about them, but the bank most assuredly has people that can help you.
Also, contrary to what your posts suggests (any serious amount of money), the amount of money has no bearing on how you would hedge its risk.
According to the Shareholder's Letter, the 5 funds of funds in the bet portfolio were comprised of funds that largely did charge 2/20, with the fund-of-fund charging an addition 1% plus performance on top of that.
> The notion that hedge funds all collect a stereotypical management fee of 2 percent and a performance fee of 20 percent has been dying a slow death in recent years, especially for smaller, newer funds.
I said 2/20 fees aren't the norm anymore. You quoted from the letter. I provided a source that shows hedge fund fees are going down and remarked that the Buffett bet started before the 2008 crash when fees were higher then they are now. Because it was a boom period and because index funds that push down management fees have only recently become popular.
It seems to be that either Buffett must be mistaken or you are, right? His claim is that the funds involved in the bet are 2/20 funds, and while the bet started in 2008, it is still running today.
Technically, he claims they pay less than 2/20 but no details are provided. Nowadays 2/20 fees are considered high, not the norm. Fees are trending down. This is something you can easily verify. Buffett did say 2/20 is the "prevailing hedge-fund standard" but he's mistaken.
I guess. Mostly, I've just been nerdsniped by the claim you made that the timing of the bet could invalidate it's claim. It's a 10-year bet, so Buffett has in fact maximized his exposure to the phenomenon you describe.
>Secondly, every trade has a counterparty. So somebody necessarily has to be at the loser's end of every trade.
This is not true. There will always be someone who wins less between the two, but it doesnt mean it wasnt a win-win trade. Some things are more valuable to one person than another.
Not only do you get on average better returns, you can do better even when they perform poorly since those funds (in Canada) can charge you anywhere from 1.5% to 3% of your portfolio in fees (MER), while an index fund could charge as low as 0.1%.
https://www.wealthsimple.com/ (I'm a customer) has recently expanded into the US from Canada and are one of a group of what is being called Roboinvestors which take these index funds and let you easily invest in them.
Wealthsimple adds on 0.5% fee which is still lower then active funds, my portfolio has a weighted MER of 0.64%.
My personal view of using Wealthsimple is a stepping stone, I've realise that I've throw away money to the banks with higher then needed MERs and Wealthsimple provide a easy way of transferring my money in and saving money now. When my portfolio is larger and I'm seeing a higher cost with them VS doing it myself I'll look into buying ETFs myself.
The lowest bank mutual fund in Canada that I've seen in from Tangerine at ~1% MER, are there ones lower?
> The lowest bank mutual fund in Canada that I've seen in from Tangerine at ~1% MER, are there ones lower?
Without having to handle rebalancing yourself? AFAIK then Wealthsimple and Tangerine are already the lowest you'll find without working with ETFs or index funds directly.
I just wrote about this, but if you read his 2005 letter(when he proposed the bet), he mentioned changing allocations can be much more disastrous than fees. Here's the link, which my first point covers: https://www.linkedin.com/pulse/3-things-you-might-have-misse...
>> You get close to the return you'd get by investing in real estate
Close to the return on unleveraged real estate investing. Most real estate investing is significantly leveraged, to a larger extent than possible (or recommended) for stock market investing.
>Most real estate investing is significantly leveraged, to a larger extent than possible (or recommended) for stock market investing.
But the market will adjust to cheap leverage. Easy money, house prices go up, you get less value per dollar. So the benefit of leverage is diminished at least a bit.
> a standard index fund outperforms almost every hedge funds even before extra fees
Hedge funds beat the market before fees [1]. (Mutual funds do not [2].) It's just that hedge fund managers are great at gobbling up that alpha with fees.
One way to look at this is hedge fund investors subsidise the efficient price-discovery function hedge funds provide the market.
He then goes on to show how that's been true, and that a standard index fund outperforms almost every hedge funds even before extra fees to the hedge funds are taken into account.
It's not the first time this has been pointed out, and it suggests that for non-multimillionaires, an index fund is always the most rational choice.
You get close to the return you'd get by investing in real estate, with the added benefit of index funds being much more easily liquifiable.