Notes, Views, and the Occasional Provocation May / June 2008  

One day last week, it was so hot in our Presidio office that the fan itself seemed to want to close shop and go home. The next day the fog rolled back in, and I saw a woman walking down the sidewalk wearing a wool hat and mittens. It's summer in San Francisco.

The markets haven't felt much different lately. Hot one day, cold the next, with not a lot in between. Is it time to run for cover? Warren Buffett would say no. As our first article discusses, he just put a chunk of change down on the S&P 500 for the next ten years. But as the second article recommends, he might suggest focusing on something other than investment returns for a while.

Please feel free to forward the newsletter to anyone who might enjoy reading it, and please send along any questions or comments you may have. We love hearing from you.

Warm regards,

Milo Benningfield

Oracle of Omaha vs. Wizards of Wall Street – The Big Bet
Think a smart hedge fund might be just the thing to navigate today's volatile markets and help protect your money? Warren Buffett doesn't think so, and he's willing to bet real money to prove it. more

Short-Term Portfolio Performance – Toxic Information
The more frequently you check the progress of your long-term investment strategy, the more likely you are to abandon it. Why? Because the more often you check, the more likely you are to see losses. more

BFA Media Quotes
Recent media quotes. more

Oracle of Omaha vs. Wizards of Wall Street – The Big Bet
Think a smart hedge fund might be just the thing to navigate today's volatile markets and help protect your money? Warren Buffett doesn't think so, and he's willing to bet real money to prove it. The Oracle of Omaha has taken on the Wizards of Wall Street, betting a select group of hedge fund managers that all the currency-arbitrage, short-selling, and quantitative modeling in the world won't help them beat the S&P 500 Index over the next ten years.

According to Mr. Buffett's longtime friend Carol Loomis, writing recently in Fortune Magazine, the origin of the bet began at the Berkshire Hathaway 2006 annual meeting:

Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking. 1

A New York hedge-fund manager, Protégé Partners, accepted the bet, and this past January, Protégé and Mr. Buffett each put $320,000 into 10-year zero-coupon Treasury bonds that will be worth $1 million in 10 years. To win the bet, Protégé's selection of five funds of hedge funds must return more than the S&P 500 Index, after fees, over 10 years beginning January 2008. The winner gets the $1 million donated to their favorite charity.

Hedge funds are unregulated, private pools of capital that can invest money almost anywhere they like:

Historically, the whole point of a hedge fund was to outsmart the market. Because their clients were rich and sophisticated, hedge funds were allowed to gamble with investors' money. Unlike mutual funds, which are strictly regulated under the Investment Company Act of 1940, hedge funds could take risks: they could buy stock options, use leverage and bet against stocks by selling short.

As conceived in 1949 by Alfred Winslow Jones, then an editor at Fortune magazine, a hedge fund hedged its bets by taking "long" positions on undervalued stock and "short" positions on overvalued stocks. The idea was to be smart and nimble and bold, and to make oversized returns.2

After Mr. Winslow's debut in the post-war years, hedge funds remained a dot on the investment landscape — as of 1968, there were only about 140 investment partnerships that the SEC considered hedge funds. But starting in the 1980's and 90's, investment legends such as George Soros, who made $1 billion in 1992 by betting against the British pound, and Julian H. Roberson, who earned an average annual return of roughly 25 percent over 20 years before retiring in comfort, put hedge funds on the map. Over the past decade, the total number of hedge funds exploded to 8,000 funds, with almost $3 trillion in worldwide assets.

But not everyone can be George Soros in 1992 with the British pound. (Not even George Soros; two years later, trading in Japan, he lost $600 million — in a single day.) As the funds proliferated, so did mediocrity. A few years ago research by Burton Malkiel, a professor at Princeton, showed that over long periods, hedge funds significantly underperformed the U.S. market, as measured by the S&P 500 Index. From 1996 through 2003, hedge funds as a group produced an annual return of 9.3%, versus 9.4% for the S&P 500.

More recent data shows a similar trend:

This would no doubt shock many affluent investors who have been sold on the idea that smart Wharton MBA's operating funds behind closed curtains must have something special to offer. But there are many reasons for hedge funds' increasingly mortal status — too little talent to go around; too many managers chasing similar strategies; and the ever-present fact that the person on the opposite side of a trade is someone . . . just like themselves.

But the biggest hurdle any hedge fund must overcome to deliver returns to investors are the funds' steep fees — typically a 2% annual management fee, plus 20% of any profits. That is, every year a hedge-fund manager will take 2% (sometimes lower) of the assets he manages as his paycheck. If he happens to earn a profit above a pre-set high-water mark, he also takes 20% of the "profits" above that mark. This was the original fee structure put in place by Alfred Winslow all those years ago, and it is why Warren Buffett refers to the hedge fund managers derisively as the "2-and-20 crowd."

Thus, as Carol Loomis explains, for Protégé to win the bet, their selected hedge funds must not just beat the S&P 500 Index, but beat it by a wide enough margin to overcome their high fees:

As for the fees that investors pay in the hedge fund world — and that, of course, is the crux of Buffett's argument — they are both complicated and costly. A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones ‘bought' by Buffett in the bet.

On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the 'helpers' that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

The summation is pretty obvious. For Protégé to win this bet, the five funds of funds it has picked must do much, much better than the S&P.3

In taking on the hedge-fund managers, Mr. Buffett knows he is taking on the purported best and brightest, the gunslingers with nerves of steel whom Business Week described in a 1994 article as a "widely feared subculture." That he is taking them on by selecting as his sole horse the Vanguard 500 Index Fund suggests an audacity not seen since Gary Cooper in High Noon.

He's placing a great deal of faith in capturing market returns, as he has advocated in more than one Berkshire Hathaway shareholder letter. And he's making an argument: investment costs matter more than wit, especially over long periods of time.

What he is not doing is also interesting. He is not diversifying into foreign markets — no China or Brazil, no Germany or Japan for his portfolio. Thus, he is ignoring an easy hedge against future dollar declines as well as more than 60% of the world's $37.4 trillion of market capitalization (as of December 31, 2007).

Perhaps he is giving those poor hedge-fund managers a sporting chance. After all, they have to deliver some fancy footwork to overcome those investment costs — perhaps corner the market on ten-year Treasury bonds again, exploit the Thai baht, or use arcane mathematical models to arbitrage momentary blips in stocks, bonds, and / or derivatives.

That said, whether Mr. Buffett will win his bet is far from clear. He himself assesses his odds at 60%, "which he grants is less of an edge than he usually likes to have."4 He more than anyone ought to know what he's up against. After all, back in the 1950's, before purchasing a little-known textile company called Berkshire Hathaway, before playing bridge with his friend Bill Gates, and before his ascendance to the Temple at Omaha, he, too, toiled in the financial trenches a few years as a mere mortal: he ran a hedge fund himself.

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Short-Term Portfolio Performance – Toxic Information
The more frequently you check the progress of your long-term investment strategy, the more likely you are to abandon it. Why? Because the more often you check, the more likely you are to see losses.

The reason is volatility, or the amount by which growth portfolios comprised largely of stocks tend to fluctuate over time. Mathematician and trader Nassim Taleb illustrates this point elegantly with the parable of a dentist in his book Fooled by Randomness. The happily retired dentist is an excellent investor who can expect to earn a 15% return on his portfolio each year, with a 10% standard deviation (volatility).5

Statistically, this means that two-thirds of the time his investment return will fall between +5% and +25% a year. Ninety-five percent of the time, the annual return will fall between -5% and +35% — a gift from the gods.

But these are capricious gods, because there's a catch: the more frequently the dentist monitors his investment progress, the more often he will see that he is losing money. Using the assumptions above, Taleb calculates the probability of the dentist making money over different time intervals:

Timescale Probability of Making Money
1 Year
1 quarter
1 month
1 day
1 hour
1 minute
1 second

If the dentist checks performance once before dinner each night, he will experience the pang of loss roughly every other day. If he can wait until the end of each month, he'll see losses a third of the time, enjoying eight out of twelve brokerage statements each year. And if, over the course of twenty years, he could spend his days reading Kant, tying fishing lures, and waiting until the Super Bowl each year to check performance, he would receive good news 19 out of 20 times and no doubt be a very pleasant (and knowledgeable) man to watch the game with.

Taleb's hypothetical scenario plays out similarly with the real-world, historical results of the U.S. stock market, as measured by the S&P 500 Index. Over the last eight decades, starting in 1926, investors focused on twenty-year intervals would have experienced a smooth, ulcer-free ride, earning an average annualized return of over 11% a year, with less than a 4% annualized standard deviation (volatility)6:
But if they had bothered to look under the hood of that smooth ride each year, here is the "shocking truth revealed!" they would have seen — an average annualized return of about 12% a year, with a teeth-rattling standard deviation of almost 22%:
Even if you possess fairly good emotional shock absorbers, the chances are still high that such yearly volatility could derail your long-term investment program. The reason: most of us are subject to well-documented behavioral biases:

  • We overweight the most recent information. (e.g., last quarter's investment results.)
  • We overreact to dramatic information or dramatic circumstances. (e.g., news of a hedge-fund collapse or bank failure.)
  • We tend to have what's called outcome bias, meaning we judge things on their outcome, not their process. (e.g., looking solely at investment returns without asking how much risk was assumed to earn them.)
As the behavioral economists have taught us, we are, in short, not wired to understand that short-term investment results amount to little more than variability, or noise. Our neurobiology simply works against us:

What economists did not understand for a long time about positive and negative kicks is that both their biology and their intensity are different. Consider that they are mediated in different parts of the brain — and that the degree of rationality in decisions made subsequent to a gain is extremely different from the one after a loss.7

So how do we filter out the noise to focus on information useful for evaluating our long-term investment strategies? The answer depends on how you intend to use that information and on your investment timeframe.

Are you trying to figure out whether your mutual-fund managers have any idea what they're doing? Then you'll need to wait at least several years.

"Short-term performance is largely a matter of luck," according to James Gipson, former legendary lead manager of the Clipper mutual fund. "You need 5 to 10 years to establish the skill and diligence of the investment manager and to sort that out from the element luck." Some financial economists argue you need even longer — as long as four, six or sometimes eight decades – to gather statistical evidence sufficient to say whether a manager or investment strategy was skillful or simply lucky.

Are you investing for tomorrow or, as most individual investors, for a minimum of thirty, forty, or fifty years to meet retirement and other long-term goals? If the latter, then you need to be careful about drawing any conclusions from returns data shorter than three to five years. The danger isn't just being disappointed with results. Investors are just as easily tripped up by overconfidence due to short-term fortune as they are by despondency due to short-term loss.

In general, we recommend analyzing investment performance no more than once a year. Waiting to look annually at performance variables such as standard deviation (volatility), relevant benchmarks, and the returns themselves provides some filter to the periodic swings inherent in growth assets. An annual review also ties to the larger context of a financial plan that is itself linked to such annual events as tax planning and retirement savings.

To be clear, we are talking about investment performance, not just returns. How much risk you took to earn a particular return is as or more important than the return itself in determining whether you were well-compensated.

Above all, we recommend against the seasonal approach taken by most investors to analyzing portfolio returns. Measuring changes in winter, spring, summer and fall is important for farmers and fishermen. But examining forty-year portfolios every ninety days is useless for long-term investors. Worse, it can actually be toxic, by maximizing noise, obscuring knowledge, and placing you at risk of burning out on randomness. Ask yourself, "What would Warren do?" and note how often he will report the progress of his bet on the U.S. stock market (described in the article above): once a year, at the annual Berkshire Hathaway shareholders meeting.

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Recent Media Quotes
Business Week Online, June 12, 2008
Milo was quoted in Ben Steverman's article "Beware of Higher Interest Rates." Milo noted that "[t]rying to forecast [interest rate moves is] like trying to forecast the weather in San Francisco." But if you're investing in bonds for the long term, higher rates are actually a good thing: "If you invest in bonds, 'you actually want those interest rates to rise because you're a lender. . . . '[It] can be painful in the short term, but in the long term, you're better off,'" since investing in bonds, whether through a fund or a bond ladder, involves constant purchases of new bonds and reinvesting at higher rates. Read the article.

That's it for now. Thank you for reading. Please look for our next newsletter in August. Until then, have a very good summer,

Milo Benningfield

1 "Buffett's Big Bet," Fortune Magazine, June 9, 2008.

2 "Gunslingers No More: The Cautious Cash In," New York Times, May 22, 2005.

3 "Buffett's Big Bet," Fortune Magazine, June 9, 2008.

4 Ibid.

5 Fooled by Randomness, Nassim Nicholas Taleb (Random House 2004), pp. 64-65.

6 Thank you very much to Jay Totten at Dimensional Fund Advisors for suggesting and compiling this data.

7 Fooled by Randomness, p. 68.

8 "How Some Mutual-Fund Hot Shots Fell Behind," Wall Street Journal, October 22, 2004.

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