Buffett versus the Hedge Funds

It is with trepidation that I take on the world’s greatest investor. Warren Buffett’s company Berkshire Hathaway, has produced returns for investors of over 20 per cent per annum over the last 50 years – and it is pretty hard to argue with that.

However, there is something concerning Buffett that I query and this year he refers to it again in his shareholder newsletter.

This is a bet that he has taken with a hedge fund manager that the S&P 500 will give better returns than five hedge funds over a ten-year period.

The wager is for $500,000 and Buffett is well ahead: the S&P 500 has produced 7.1 per cent yearly over the last nine years, whereas the hedge funds languish at 2.2 per cent. (All these returns are after fees).

My beef with Buffett’s bet is that a share index and hedge funds are quite different things. Buffett’s horse in the race is the S&P 500. This is made up of 500 companies and the performance of the index depends on how well those companies do.

On the other hand, hedge funds have all sorts of different strategies: arbitrage, long-short, derivatives, foreign currency, distressed securities – they trade anything that might make a buck. To compare hedge funds to a share index is like comparing a butterfly and a baboon.

Hedge funds started in the 1940s to hedge risk. Originally, they did this very successfully and managed to get high returns. However, they changed over the decades and adopted other strategies to the point where today they do not do well. In fact, they now seem to be mostly an unabashed vehicle for managers’ fees.

I am no fan of hedge funds or their fees and I do not invest in them. Nevertheless, although I do not like hedge funds, it is unreasonable to have a competition between two quite different asset classes and one which compares returns without considering risk. It is possible the hedge funds have show less volatility than the S&P 500 over the 9-year period, and this is one of the reasons people buy hedge funds.

An investment is not poor simply because it gets low returns. Term Deposits are a low-returning investment but they are also low risk. They are therefore, a very good investment for some people in some circumstances. They are the best investment possible for those saving for the short-term.

To say that the S&P 500 is a better investment than a collection of hedge funds without measuring risk, is like saying that Term Deposits are a poor investment. You cannot compare returns if you have not adjusted for risk. It is easy to get high returns, you just take on more risk.

Buffett was quite smart when he set up his wager. Although it will prove the S&P 500 gives better returns, it proves nothing about which is the better investment. I admire the man more than anyone else in investment, but Buffett is being disingenuous to crow about returns without measuring risk.

Martin Hawes is the Chair of the Summer KiwiSaver Investment Committee. He is an Authorised Financial Adviser and a disclosure statement is available on request and free of charge, or can be found at www.martinhawes.com.

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