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The Warren Buffett hedge fund that wasn’t

Warren Buffett: Doesn’t run a hedge fund

There are many things that make Warren Buffett remarkable, as you’ll know if you’ve read The Snowball, his biography.

There’s his appetite for junk food, and how his first wife selected his second. There’s also the fact there’s no Warren Buffett Hedge Fund.

Instead, what is now Berkshire Hathaway was born out of nearly a dozen investment partnerships that Buffett created and ran for his family and friends.

When these were wound up, many of the partners rolled their money together with his, on equal terms as shareholders. They were then made fabulously wealthy over the decades as the greatest ever investor compounded their shareholdings.

Buffett’s investing and business activities made himself rich, too. At the peak of his wealth in 2008 – before he started giving it away – he was the richest man in the world, with a fortune of $62 billion.

The Buffett Hedge fund that wasn’t

A win-win scenario for Buffett and his partners, you might think – but it’s not a good enough win for a hedge fund.

These typically charge 2% annual fees for managing your money, and 20% of any outperformance – and as a result they devour your gains.

Just how much could you lose from fees? Here’s a worst case analysis of hedge fund fees by Terry Smith, the CEO of £1 billion city firm Tullet Prebon:

Warren Buffett has produced a stellar investment performance over the past 45 years, compounding returns at 20.46% pa.

If you had invested $1,000 in the shares of Berkshire Hathaway when Buffett began running it in 1965, by the end of 2009 your investment would have been worth $4.3m.

However, if instead of running Berkshire Hathaway as a company in which he co-invests with you, Buffett had set it up as a hedge fund and charged 2% of the value of the funds as an annual fee plus 20% of any gains, of that $4.3m, $4.0m would belong to him as manager and only $300,000 would belong to you, the investor.

And this is the result you would get if your hedge fund manager had equalled Warren Buffett’s performance. Believe me, he or she won’t.

Smith’s article has been criticised because a hedge fund wouldn’t usually reinvest the 2% management fee back into its own fund, and compound that over time. It’s this compounding of the fees that really results in the huge gains for the hedge fund in Smith’s example.

I don’t agree with this criticism though; Buffett’s own record sees all invested money compounding at 20.46%, so it seems reasonable to assume the fund does the same to make a comparison – even if in reality hedge fund managers would spend their fee money on Monaco apartments and Lamborghinis.

Another criticism is that Smith assumes the hedge fund always gets its 20%, whereas in reality there is a high water mark which means in years where it underperforms it would ‘only’ get its 2% management fee, until the portfolio breached the previous high.

As far as I can see this is mathematical shorthand though, unless you’re prepared to download Buffett’s returns every year and plug those into a hedge fund modelled on the 2/20 structure.

On balance, I think Smith’s point is well made. Not least his throwaway last line, about whether your hedge fund manager would match Buffett’s record.

Don’t hold your breath! The average hedge fund is currently delivering the same performance as a simple basket of index tracking ETFs, and the latter charge barely 0.5% a year.

How to make $50 million

You might well ask if Buffett is so smart, why didn’t he start a hedge fund instead? There were many such funds in existence by 1965, and Buffett’s first employer Graham Newman was essentially a hedge fund.

And the answer is – he did!

In the days before Berkshire Hathaway, Warren Buffett ran those partnerships I mentioned along hedge fund lines. This was how he initially made his fortune.

Yet even these weren’t run following the 2/20 standard of hedge funds. To quote Buffett from The Snowball:

“I got half the upside above a 4% threshold, and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited.”

Normal hedge funds take no hit in negative years, so Buffett was already doing things differently. Then he did exactly what critics of Smith’s calculations say no hedge fund would really do – Buffett reinvested the fees he drew from his partners back into the partnerships, compounding his own share of the capital year on year.

Like this, between 1956 and 1967, Buffett increased his net worth from $172,000 to over $9 million.

That’s well over $50 million in today’s money, which he’d earned by the age of 37.

Don’t bank on finding another Buffett

Buffett’s supreme confidence in his investing abilities and a favourable market meant he never took the downside of his unusual fee structure – because there were no years where he made less than 4%!

The legend of Buffett might be very different if he’d had a bad year. We’d probably never have heard of him today if he’d had a few bad years in a row.

Perhaps Buffett, too, had realized this by the 1970s, when he wound the partnerships down and instead lumped his money in with that of his most faithful investors to co-own the collection of companies that became the modern Berkshire Hathaway.

These first investors and those that later bought Berkshire stock were lucky Buffett didn’t foist the 2/20 rule on them, that’s for sure. They were made immeasurably wealthier by the arrangement.

Yet I suspect from my reading of Buffett that he’d say luck had nothing to do with it. They were his partners, not his clients, and it was having their backing that enabled him to act with the confidence and boldness that has defined his five-decade career.

The bottom line: There is no Warren Buffett Hedge Fund because while he is an implacable acquirer, Buffett doesn’t think like a hedge fund manager. He thinks – and always has thought – like a business owner, and a shareholder.

The other bottom line: Avoid high fees and hedge funds like the plague.

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{ 6 comments… add one }
  • 1 ermine October 5, 2010, 3:37 am

    WB is unique in what he does, and perhaps you’ve boiled it down to the essentials in
    > He thinks – and always has thought – like a business owner, and a shareholder.

    Too many of us stand back from that, we invest in ETFs without wanting to engage, and we chase average returns because we commit average effort. When I bought individual shares, I chased momentum, and lost out. It’s a totally different mindset from when I invested in my own company – the latter didn’t set the world on fire, but paid a better ROCE than my FTSE ETF 🙂

    Warren Buffett is onto something there wiht the thinking as a company owner. Shame it’s such a bugger to replicate 😉
    .-= ermine on: There’s nothing wrong with Schizophrenic Investment =-.

  • 2 Salis Grano October 5, 2010, 8:09 pm

    I try always to take an interest in the companies I “own”, but it can lead to weird kind emotional attachment that prevents you letting go when you really should. -SG
    .-= Salis Grano on: What I do and what I dont =-.

  • 3 OldPro October 9, 2010, 8:22 pm

    Its often seemed odd to me how Buffett lef these partners of his come along for a free ride… by running a company not fund… guess that’s capitalism, that’s shareholders… they were entitled to the slice they left with him from his partnership/hedgie days if my memory serves, but you have to say — what a deal!

  • 4 Andrew @ Money Crashers October 10, 2010, 6:13 am

    Even though people can argue with the math as you mention, that is absolutely crazy how much of the $4.3 million you would have lost if things had been structured as a hedge fund with the 2 and 20 rule. I had to do a double take on that stat.

    Hedge funds are truly a crazy beast. I would say only invest there if you are absolutely loaded and the hedge fund has an unbelievable track record and a truly unique and almost fool proof investing strategy. Otherwise, it’s tough to rationalize such high fees.

  • 5 Richard Stooker January 20, 2011, 4:23 am

    This is an important article — which should be read by every wealthy person considering an investment in a hedge fund.

    That’s because, in the active investing vs index fund debate, Warren Buffett is held up as the shining example of an active investor who has successfully beaten the market long term.

    And to attract investors, hedge fund managers must convince prospects that they too can beat the market long term, and so deliver gains worth their high expenses (and often, restrictions on capital liquidity).

    Yet, as you show, even if the hedge funds can duplicate Buffett’s performance, they can’t deliver the same returns to investors, because of their management fees.

    As John Bogle loves to point out, expenses matter. A few tenths of a percent management fees separate mutual fund winners from losers. So the predatory fees that hedge fund managers charge really take a bite from long term returns.

    To me, the existence of hedge funds just proves that you can be smart in business but dumb about investing. Just look at the list of people Bernie Madoff bilked. Hedge fund managers can be honestly trying to make good trades, however, and still not be worth their fees.

    The real smart money invests in low-cost index funds.

    And the very smartest money invests in stocks that pay dividends (my bias).

    Essex Property Trust

  • 6 Stefan April 30, 2012, 11:12 pm

    Let me get this straight. Lets assume you bought a company for $1,000,000 that was giving you an anual 20% return. A Hedge Fund with a 2/20 rule would get:
    1. 2% of $1mil = $20,000
    2. 20% return of $200,000 = $40,000
    Total for Hedge Fund: $60,000

    What about using the Buffet Strategy:
    1. 20%-4%= 16% x $1mil = $160,000 x 50% = $80,000.

    Would you rather pay $60,000 or $80,000? Remember this is a 20% return, which is what Buffett has averaged so it should not make a difference if the investment is $1million or $1billion, 20% is still 20%.

    Am I missing something?

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