Warren Buffett's bet against hedge funds at the Long Now Foundation (2008-17)
longbets.org
longbets.org
And if you include taxes in those fees and the benefit of deferred tax liabilities it's even harder to beat an index fund.
* It's reasonable to be skeptical about any fund having a goal that's anything other then maximizing long-term returns.
> * It's reasonable to be skeptical about any fund having a goal that's anything other then maximizing long-term returns.
I really don't think it is. If I'm a sophisticated investor, I may want to invest in funds which hedge against tail-risk, or provide broad exposure to some specific sector, etc. Neither of these things are about maximising returns relative to the S&P500. There are strategies with negative expected returns in the long-run, but when added to a portfolio can improve its returns. Portfolio construction can get very complex.
And, regarding being skeptical of things like "hedging risks" and "complex portfolios," I don't know. I'm just not sure enough hedge funds really do a great job handling tail risks to not be skeptical of all of them as a group. And, surely sophisticated investors can target specific sectors and build arbitrarily complex portfolios (if they're into that sort of thing) with passive things like ETFs for much lower fees on their own.
I'm not talking about all hedge funds managing tail risk for their own portfolios, but funds which are designed to do nothing but hedge against tail risk. They provide a valuable service, and a small allocation to such a fund in concert with a large holding in the S&P500 will often outperform the S&P500, even if the fund itself loses money.
This isn't clear to me. To me it seems rather that this is a bet against hedge funds. I can see a way to your interpretation but it does not seem as likely to me.
Quoting the shareholder's letter from 2016 [1], the actual bet was "that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. [...] For Protégé Partners’ side of our ten-year bet, Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund."
Do tail-risk-targeting hedge funds have a better incentive than 2-and-20? Honest question, I have no idea. I assume 2-and-20 drives shooting for the moon and closing the fund if it doesn’t work out.
I confess to having drunk the Kool-aid and can report that I no longer have investment anxiety.
One thing to be cautious of here is that people often overinvest when they have some sort of advantage, and become way too over-leveraged in one single area.
I remember a calculation from a college finance class. Imagine you have an otherwise "optimal" portfolio with 1% of its assets in a particular large stock, but you know that the real average returns of that stock are going to be ~2x what the market is expecting. So you recompute the efficient portfolio with this new information and find the new optimal weight of the stock and it's only something like 2-3% despite having a very strong information advantage over the market.
But most people would think this sounds crazy. "I've got a crazy inside stock tip that it's worth double what everyone else thinks? Shouldn't I put at least 10% of my money in there?" No. Diversity is a hell of a value-add in a portfolio.
Interestingly, most managers actually do match the S&P500, but before fees. I don't have a link handy, but there have been some academic papers on their performance.
To majorly out perform or underperform you have to be drastically different.
so what exactly are you paying them their fees for then?
Either way, for an active manager to be worth their fees, they _have_ to beat the index by more than their fees plus a bit more to make up for the risk that they don't. Otherwise, you'd be better off in a passive fund.
Nothing can be.
Buffet himself has a couple factors that help him outperform which you and I likely don’t. For one thing, he often buys private companies (not a liquid market with constant price discovery like the public stock market). That’s not uncommon, even if it’s out of reach of most retail investors. More unattainable for the rest of us, he has the “Buffett Halo” effect: stocks often go up just because he bought them! This effect also induces companies to give him a discount on equity, because the existing shareholders benefit from the halo. Obviously Buffett must still work hard to choose stocks wisely, or the halo would evaporate over time.
the “Buffett Halo” effect I dont think is fair to include. This is very real but its also temporary. Consider stuff like his failed Tesco investment. Long term we get back to fundamentals.
The big advantage I think worth mentioning is Buffet also buys control much of the time he invests. You and I buy shares to go along for the ride. He buys in on value + they ability to control direction + typically do share buybacks that further increases the per-share value and uses the companies own money to grow value further. This is a real game changer beyond the traditional value approach you and I will never have.
1. Their major thinking is that the growth of index funds is driven by volume of new investors, not necessarily market performance. At some point we hit the diminishing returns of new money into indexes. When that happens we'll see their "guaranteed" growth slow and you'll need to turn to hedge funds for alpha. He thought 10 years was enough for this to play out. Obviously wrong on timing, but not necessarily wrong on outcome.
2. One of the conditions of the bet was that they have lunch once a year to discuss bet progress. Given that charity lunches with Warren are going for 4.5mm today, they essentially got 10 lunches for 100k each. That is...quite valuable for a hedge fund manager.
Now, nobody can sell a loss better than a hedge fund, so I take with a grain of salt. But it is some food for thought.
Having spent most of my career as a hedge fund trader, I absolutely agree with Buffet. But I think a decade of the largest monetary interventions skew the numbers massively in favor of a long only passive investor.
It would be interesting to see the distribution of returns among the contained funds. I lean heavily passive personally, but at least if a not-insignificant fraction of funds outperformed the index and were dragged down by really bad returns in others, it would give some indication as to why people would even _try_ to actively pick where to put their money...
Any time you reduce the sample size, you increase the variance, which gives the impression that skill is involved. In fact from just looking at a single distribution of outcomes it's not possible to tell if skill or luck is the cause.
I would call that sufficient evidence to reject the null hypothesis that the returns are normally distributed, which is to say it's not luck. If you expand your sample size to all investment vehicles throughout history, there still haven't been anywhere nearly enough for such a track record to emerge by chance.
Elementary statistics is well equipped to distinguish between a distribution signifying luck and a distribution signifying skill. It's structurally the same as assessing normality, noise, randomness, etc.
the problem is that _many_ funds have positive returns until, suddenly, they don't. It's basically as hard to pick a fund or money manager for the long run as it is to pick a stock.
Consider Neil Woodford[0], he beat the market for over twenty years and was considered the best investor in Britain. Then started a new set of funds, which went terribly. It'd have been reasonable to let him manage your money, but it would still not have worked out.
Buffett outperformed SPY for most of his 60 year career. Do you think he doesn't know what he's doing, and it was all luck, just because Berkshire Hathaway isn't doing as well as it used to?
> For an average fund in the cross-section, we estimate a drop in alpha of 20 basis points if the fund doubles its size over one year. We also find a non-negligible impact of the size of the fund industry, although its magnitude is significantly smaller than the impact of individual fund scale. We reconcile our findings with existing empirical studies. Taken as a whole, our results lend considerable support to theoretical models that build on the premise of decreasing return to scale for active portfolio management.
* https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2872385
General topic discussed in the Rational Reminder podcast:
* https://rationalreminder.ca/podcast/136 (~15m30)
* https://www.youtube.com/watch?v=LhluPwDaNAQ&t=18m30s
Something to consider for anyone piling into (e.g.) ARK:
* https://awealthofcommonsense.com/2020/12/a-short-history-of-...
For example, a single investment in Amazon 20 years ago would outperform the market by many sigma. But the probability of an average fool having picked that particular stock 20 years ago was not 10^-(some large number). At least 1 in 100 fools would have picked Amazon.
How exactly do you make the jump from returns not being normally distributed, to that meaning beyond doubt that luck isn't involved?
In exchange the fund managers would get fees and excess returns on their clients capital.
This way instead of arguing over which approach is better, both groups can benefit from one another.
An example could work like this:
Someone (Goldman, why not) starts a fund called the AlphaPlus fund. Its a mutual fund. You pay a 10% up front commission to get into it, and can withdraw your money whenever you want. Goldman promises to return the exact same as the S&P 500 *PLUS* 1% apr.
Say I hold for 5 years and want to get out. The S&P goes up 10% per year during that time. Goldman owes me whatever an 11% rate of return on whatever I invested up front.
Say I hold the fund for 5 years and want to get out. The S&P has a rate of return of -12% apr. Goldman owes me a -11% rate of return on my principal.
Goldman does this because they get a fat 10% upfront fee from me, plus they can use their super-wizard skills to invest my money in something that returns like 30% apr. Thus, their profit is fees + however much they can beat the market by (and the 1% they owe me).
(edited to give better example given access to keyboard)
Several funds have performance fees. It's typically the high-water mark (HWM) fee for profits above reference index returns.
In hedge fund land a high water mark means that if a fund loses money they won't take fees again until they've gotten back to their original high water mark.
ie you invest at 100, they gain 10% after fees so your units are worth 110.
The next year they lose 10% so your units are worth approx. 99.
Now the high water mark is 110.
Next year they make 5% so your units are worth approx. 104%. T his year the fund doesn't take performance fees as they haven't cleared their high water mark yet.
Point being the high water mark is relative to their own fund and has nothing to do with the market or any other benchmark.
If a fund only takes performance fees after a certain hurdle rate that is becoming more common but would be described by some other term.
You are guaranteed alpha at exactly 1%. Goldman makes fees and infinity ROI for taking risk. Win-Win.
if they could do that, they could just keep that 20% and they'd be already ahead. Why do they need to pay you 1% for your money?!
Das Capital!
Say I'm an investing wizard - I can generate 20% returns on any money invested.
Scenario 1: I have 100k capital, which means after one year, I'll have 120k. I made 20%, but in practice that's 20k.
Scenario 2: Now say I sell to you my wizarding ability by giving you 10% and keeping 10%. I'm giving you half the upside. However, you are a rich bank that invests 100m. I turn it after one year into 120m, give you half of that and keep half, so you've gotten 10m and I've gotten 10m.
Now percentage-wise, obviously I'm ahead in scenario 1, but in real terms, obviously I prefer scenario 2 - I've gotten 10m dollars instead of 20k dollars.
Btw in the real world, if I have to invest more money, my prowess goes down. So with 100k I can do 20%, with 1m I can do say 19%, etc. So what you'd expect to have happen is that more and more people will invest, because it's worth it to them, until eventually my abilities go down to just generic S&P level. Up to then, it's worth it for every extra investor to invest, because even if I'm only beating the market by 1%, that's a lot, but eventually I'm managing enough money such that I'm just rivaling the S&P. So from the outside, it looks like I'm not really doing anything special, but it was totally worth it for every investor until now.
[0] https://web.stanford.edu/~wfsharpe/art/active/active.htm
It's not surprising there exist individual people who are capable of beating the market, just like it's not surprising there exist people who can play sports at an elite level. You likewise wouldn't expect every human to be able to play at the elite level.
Aggregate performance should cluster around a point of central tendency.
* https://www.fool.com/investing/2019/12/22/5-reasons-warren-b...
He had a good run though. See "Buffett's Alpha":
* https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3197185
He's not really an "active" investor in the sense he uses the term, I think - his ethos is to buy and hold for a long time - almost the polar opposite of the "managed funds", isn't it?
This changes the equation somewhat since he can swoop in (dangling a billion dollar check) and do all sorts of research and investments that are unavailable on the open market.
He also (through Geico and other insurance holdings) gets to invest a ton of borrowed money at what amounts to a negative interest rate. (insurance premiums are, in aggregate, a loan to the insurance company until the customers need that money back. With the added benefit that you can repay less than you were given if your business ops are lean enough. That's why Geico pushes to do sales over the phone or internet, much cheaper than agents).
I am, of course, butchering this explanation. If you want an inside look at what he's doing, his letter to shareholders lays it ALL out.
Not saying it would be a good bet, and not the theorem isn't a good heuristic, but it's not as clear-cut as you're saying.
Edit: I also clicked on the link and it doesn't claim to be a theorem or have a formal proof, it just gives heuristic arguments against using active management, which, again, good rules of thumb, but not ironclad proof in the sense you meant.
1. Buffett bet against aggregate performance of hedge funds as an investment vehicle. If he restricted his focus to the highest performing funds of the past 10 - 30 years, he would have lost handily.
2. Buffett used absolute returns as the performance metric, not risk-adjusted returns. A portfolio with lower absolute returns but a significantly better idiosyncratic risk profile (and correlation to market/beta) can be superior to a portfolio with higher absolute returns but also higher risk.
Taken together, this means that Buffett's bet is a statement about the aggregate performance of the industry. It is not instructive for what performance is possible, or even for whether or not you should invest with the modal hedge fund (given the opportunity). It depends on investment goals and risk needs. It's also worth pointing out that "risk needs" is multi-dimensional, not just a sliding scale of how much e.g. leverage you're willing to accept. There is an entire sub-industry of hedge funds which explicitly expect to underperform on an absolute basis for long periods of time, but which service their clients with highly bespoke risk products. Clients are frequently well-informed and happy with this arrangement.
I say this because there is a tendency for people outside the industry to come away thinking hedge funds are a scam. Which...well, many are, to put it bluntly. But it's a lot more complicated and this isn't really the smoking gun you'd think it is.
I don't think this is a caveat. I think this is the point. You don't compare yourself to the literally one guy who won the lottery, you compare yourself to everybody that bought a lottery ticket.
> I say this because there is a tendency for people outside the industry to come away thinking hedge funds are a scam. Which...well, many are, to put it bluntly.
I don't think anybody is assuming every hedge fund on Earth is a scam from this any more than they think lottery tickets are a scam. As you mentioned yourself:
> Taken together, this means that Buffett's bet is a statement about the aggregate performance of the industry.
I apologize if I'm being presumptuous, but is this not so obvious that it can be assumed?
You can't derive a conclusion about individual hedge funds from this. That might seem obvious to you, but maybe you'd be surprised then :)
Fair. I've been surprised by the ignorance of people before, including myself!
"Risk-adjustment" is just another metric which makes not much sense: either I have the money or I do not. Money now is worth more than possible money tomorrow.
About "the highest performing funds of the past 10 - 30", which ones, the two first ones, the Medallion fund? those which cannot be used by ordinary people?
I know Buffet is not exactly the paradigm of "ordinarity" but nevertheless, I think his intention with his stubborn support of "just the market" is to teach that "ordinary people can very seldom outperform the market".
If you think risk-adjustment doesn't make sense as an evaluation metric, you should just sell naked puts or calls on a stock which doesn't seem volatile. You're going to generate spectacular returns for a while. Then you're going to blow up.
On the other hand a portfolio with relatively low idiosyncratic risk and low market correlation (beta) might be safely levered up to a higher absolute return than e.g. SPY with less overall risk and volatility.
Like I said...it's complicated.
That is antithetical to investing...
And let's suppose that there really is a fund staffed by a group of super-geniuses who can reliably pick the best performing stocks. There are two possibilities: They take on more and more investment capital until their returns end up getting closer to the mean or they don't accept new investments and the hypothetical new investor is left out in the cold.
No, returns of the average. Regression to the mean means, well, what it says: it regresses to the mean, not past it.
Your version is what we call the gambler's fallacy!
This is not the same because outlier movement of macro demographics and financial policy does have an impact on the future. If the stock market were random on a macro scale it would average zero movement.
He let an expert pick the funds of funds. AFAIK, he didn't restrict which funds the expert picked.
> If he restricted his focus to the highest performing funds of the past 10 - 30 years, he would have lost handily.
This is like saying "If I only bet on the teams who won the world cup, I would always make money". Past performance is no guarantee of future returns.
> this isn't really the smoking gun you'd think it is.
If the bet wasn't the best way to show the relative value of these investments, is there a better way? Or is the answer really "if you need a hedge fund as part of your portfolio, you probably aren't coming to HN for investment advice"?
Yeah, that's basically the answer. Retail investors don't typically need to optimize their portfolios with bespoke investment vehicles. Their exposure and goals aren't complicated.
Care to expand on this with some examples?
Is that "funds which performed well before 2008" or "funds which have performed mostly well since 2008"? The former makes sense since the latter is largely hindsight/time travel but couldn't the challenged party have picked those funds for their side of the bet back in 2008 anyway?
This is very different to a bet against hedge funds or even an argument against them. Hedge funds are designed to serve sophisticated investors with complex needs.
> Nevertheless, the evidence from more than fifty years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice
> the year-to-year correlation between the outcomes of mutual funds is very small, barely higher than zero. The successful funds in any given year are mostly lucky; they have a good roll of the dice.
The biggest bet on longbets.com: $1,000,000 - https://news.ycombinator.com/item?id=1439613 - June 2010 (32 comments)
But, "Both parties of this bet have agreed upon an adjudication methodology that has been approved by Long Bets. They have asked that it be kept confidential."
Doh!
So Govt becomes your Asset Manager when we buy S&P Index :)
https://www.gurufocus.com/guru/david+tepper/profile
https://www.cnbc.com/2019/12/18/appaloosa-david-tepper-advic...
Any truly successful fund closes itself from investors. If you really generate profits, there is no reason to give it away after AUM reaches certain level.
Most hedge funds don't gamble, but some do have poor risk management (e.g. Melvin Capital).
The proposition of a hedge fund is actually very compelling to institutional money: range-bound returns in any type of market environment. This proposition bodes very well for say major pension funds that want to avoid market risk while also modeling out return + pension liabilities at an assumed rate of return.
Take some risk profile and then bet that low cost automatically balancing stock/bond Vanguard fund beats 90% of hedge funds over 10 years based on risk adjusted return.
That would be a closer "apples to apples" comparison vs. Buffett's bet.
Money is not a limiting factor, risk is. If you have a low risk strategy, you won't have problems borrowing money to invest in it.
Its not silly, because the amount of reward depend on amount of risk.
So, if you compare returns of different strategies/funds, you need to first rescale them to the same amount of risk
1. You invest $100,000 into a fund which has a 1% chance of returning 100% and 99% chance of returning -100% each year.
2. You invest $100,000 into a fund which has a 20% chance of returning 100% and a 80% chance of returning -100% each year.
The possible payouts are the same. The expected values are not. Given the opportunity to invest in both with no difference in fees or other structure, would you leave your decision up to a coin flip?
1. 10% chance of returning 100%, 90% chance of 0%
2. 90% chance of returning 10%, 10% chance of 0%
Same expected value in year 1, but totally different proposition. And, with compounding returns, the expected value over time is very different.
Hedge funds have both management and performance fees. Management fees exist because whatever the result, there are employees that worked to deliver it. I don't see why you think that I appropriate.
Performance fees are never structured so that incentives align. You will eventually get high-water mark (HWM) performance fees just because there is random fluctuation.
Want to know what a good year for a PM at a major platform hedge fund (P72, BAM, Millenium, etc... ) looks like? Probably in the range of 8 -12% returns, which translates to 7-figure pay days.
A more in depth explanation below from the article is linked below.
> Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional “relative-return” investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls. For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.
> Mr. Buffett is correct in his assertion that, on average, active management in a narrowly defined universe like the S&P; 500 is destined to underperform market indexes. That is a well-established fact in the context of traditional long-only investment management. But applying the same argument to hedge funds is a bit of an apples-to-oranges comparison.
> Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional “relative-return” investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls. For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.
No. The proposition of most platform hedge funds is not to beat the market. It's to generate returns in any type of environment on a risk neutral basis.
So if you invest in a hedge fund, do not expect market returns. Expect range-bound returns in any type of market environment.
Hedge funds are risk management vehicles for institutional money.
Absent that crystal ball, a portfolio of hedge funds is a strictly more expensive way of investing than an index fund.