San Juan Mountains

San Juan Mountains
San Juan Mountains: Grenadier Range

Thursday, March 26, 2015

Buffet's Bet

Warren Buffett has a message for public pensions, colleges and other institutions that invest large sums of money.....stop pouring money into expensive, high-end money managers.  Mr. Buffet is so convinced of his investment philosophy that he has made a rather large bet, by my standards, with a hedge fund manager.  Hedge funds, as you probably know, are essentially private mutual funds.  To invest in a hedge fund you need at least a half million dollars in losable money.  Hedge fund managers are famous for active trading, the opposite of Buffet's approach, as they seek to beat the market on a daily basis.  They charge high fees for their alleged trading expertise.  Most hedge fund managers charge an asset based fee of 2%/year plus an additional 20% of the profits realized on the portfolio in any year during which a profit is realized.  Despite these exorbitant fees many people and institutions continue to pour their money into hedge funds. I came across a story on CNBC.com that told me about Buffet's wager.  Here is an excerpt from that story.  The full story can be found here.  
"'The commission of the investment sins listed above is not limited to 'the little guy.' Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades,' Buffet wrote in his latest letter to Berkshire Hathaway shareholders. Buffett has long been a critic of so-called alternative investing, a category that includes hedge and private equity funds, among others. The reason is the cut they take for their services, which can make billions of dollars for the managers but far less for clients, according to the man sometimes called 'The Oracle of Omaha.' 'A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool's game,' Buffett wrote on underperformance. Institutional investors include pension funds, university endowments, foundations and sovereign wealth funds managed on behalf of countries.  Buffett already has his money where his mouth is. His famous 'Million-Dollar Bet' with the hedge fund-focused investment firm Protégé Partners is that a simple S & P 500 index fund managed by Vanguard would beat a mix of five funds of hedge funds over 10 years. Through seven years, Buffett's index fund is up 63.5 percent while the five funds of funds selected by Protégé are up an estimated average of 19.6 percent, according to a Fortune report in February."
With three years to go I am willing to wager that Buffet is going to win the bet.  I wonder if the hedge fund will pay up?  I doubt it.  As I was considering Mr. Buffet's wager it dawned on me that I own a couple of stock mutual funds myself.  I wonder how my portfolio would compare to his S & P 500 index fund?  The index fund is clearly beating the hedge funds, primarily because hedge fund managers persist in the amazingly stupid belief that it is possible to predict the future direction of the stock market, but would it beat my portfolio of stock mutual funds?  To find the answer to that question I went to Morningstar.com.  I took all of the stock funds that I presently own and I compared the ten year performance for each of my funds with the ten year average annual total return performance for the Morningstar index equivalent for each fund.  What did I discover?  Over the past ten years the stock funds I hold in my portfolio have outperformed their respective stock market indices by an average of 1.78%/year.  Now that is most interesting, don't you think?
If you are an investor you have no doubt become accustomed to hearing the mantra that managed stock funds do not outperform mutual funds that are little more than copies of stock market indices.  The reason given for the underperformance is the same reason Buffet is going to win his bet....the fees associated with managing an account.  But does it necessarily follow that all managed mutual funds must underperform index funds solely because of the fees charged by the managers?  Are there no managers who have been able to consistently outperform the indices so that after taking into account their fees the fund still does better than the indices?  Clearly the answer to that question is, Yes.  My portfolio is living proof that it can be done. 
The key to understanding what is going on here is that the stock mutual funds I hold in my portfolio are stock mutual funds that generally believe in a long term approach to the stock market.  Many of them have very low portfolio turnover percentages and many of them hold on to the stocks in the fund for years.  All of the funds in my portfolio are committed to being in the stock market 100% of the time.  None of the funds in my portfolio attempt to predict the future direction of the stock market and then make market timing moves into and out of the market to try and capitalize on those changes.  In other words, the fund managers I have hired do not believe they can, nor do they claim to be able to, predict the future.  They make stock selections based upon fundamental analysis and then hold on for the long term, just like Mr. Buffet.
My wife and I went out to breakfast earlier this week.  We were seated next to a booth where two men and an elderly woman were seated. They were talking loudly and it did not take long for me to figure out what was going on. The two men, seedy characters both of them, were making a sales pitch to the woman, who appeared to me to be a rich widow.  They were selling some sort of manufacturing machine that was expected to capitalize upon Colorado's legalization of marijuana and make anyone who invested in it rich beyond her wildest dreams.  One salesman said that it made no sense for the woman to be content with 10% returns on her investment in the stock market when she could realize 20% or 30% annual returns with an investment in their machine.  It sounded to me like they were asking her for a commitment of $1.2 million to the project.  We left before the deal was closed and I had to bite my tongue to keep from leaning over to the woman and exhorting her to run for her life. 
As I thought about that woman I realized how it is that so many people fall for investment scams.  The allure of high returns plus the equally ego-massaging prospect of investing into something so sophisticated the investor has no idea what it is, is usually enough to cause a fool to part with his money.  Several years ago I posted an article to this blog about an investment charlatan named David Mitchell.  I still hear his radio commercials on a regular basis, playing on the Christian radio stations.  He promises 20%/month returns from the stock market, with no negative months and in perpetuity.  All you have to do is go to one of his seminars.  At the seminar you will be pitched on his program of stock market prediction.  If you continue with the program you will pay him quite a bit of money to learn how to allegedly predict the future and become rich beyond your wildest dreams.  He is in Denver next week but I think I will stay home and watch the grass in my backyard turn green instead.
I received the first response to my blog that I had ever received after I put up that post.  The man who responded knew David Mitchell and told me that what he says is true.  Indeed, the man who responded told me he was a currency trader and that he too had the ability to predict the future.  He informed me that he had been quite successful in trading currencies because of his ability to know what was going to happen next.  So I issued him a challenge.  I revealed my 1, 5, and 10 year total returns on my portfolio, both weighted and tax adjusted, and asked him how his returns compared.  I never heard back from him.  You can read all about it here
There is one bet I am always willing to make with anyone dumb enough to take it.  I am willing to bet that you are incapable of predicting the future.  If you think you can predict the future, contact me and we can make a wager.  I predict that I will be taking your money from you sometime in the future.  That is one future prediction that is always true.

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