The Warren Buffett hedge fund that wasn’t

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

There’s his appetite for junk food, and how his first wife chose his second.

There’s his longevity – Buffett is still happily working at 92.

And there’s the fact that there’s no Warren Buffett Hedge Fund.

Instead, Buffett’s investment vehicle Berkshire Hathaway was born out of nearly a dozen partnerships that Buffett first created and ran for family and friends.

When these partnerships were wound up, most 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 investor ever compounded their shareholdings to the moon.

Buffett’s investing and business activities made Buffett rich, too.

At his peak in 2008 – before he began giving his money away – Buffett was the richest person in the world. His fortune stood at $62bn.

By 2023 Warren Buffett was merely fifth on the Forbes list, overtaken by upstarts like Jeff Bezos and Elon Musk.

But don’t worry! Buffet’s net worth has still nearly doubled since 2008 to $106bn.

The Buffett Hedge fund that wasn’t

All this success was a win-win scenario for Buffett and his partners, you might think.

But it still wouldn’t be good enough for a hedge fund.

While hedge fund fees have come down in recent years, these funds historically charged 2% annual fees for managing your money, as well as taking 20% of any gains. As a result they devour their investors’ returns.

Just how much could you lose from such high fees?

Terry Smith – the fund manager sometimes touted as the UK’s answer to Buffett – once did a worst-case analysis of hedge fund fees versus Buffett’s first 45 years as an investor.

Smith found1:

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.

Let’s repeat that money shot. After 45 years, the Berkshire The Counterfactual Hedge Fund would have turned $1,000 into $300,000 for its investors. Which actually isn’t bad.

But it would have generated $4m for manager Warren Buffett.

How the Warren Buffett hedge fund rankled

Smith’s analysis 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.

And it’s this compounding of the fees that really drives the huge gains for the would-be Buffett hedge fund in Smith’s example.

But I don’t agree with this criticism. Buffett’s own record sees all invested money compounding at 20.46% over the time frame, 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 bolt holes and Lamborghinis.

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

As far as I can see this is a 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.)

Buffett did and they didn’t

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! Even back in 2010 the average hedge fund was delivering the same performance as a simple basket of index-tracking ETFs. Such vanilla ETFs typically charge less than 0.5% a year.

There are certainly a handful of stellar hedge funds out there (which you and I mostly can’t invest in) that justify their fees.

But as a class, in the past decade the track record of hedge funds has only gotten relatively worse since Smith did his analysis.

Study this table of returns from respected commentator Larry Swedroe:

Swedroe comments :

Over each of the one-, 10- and 20-year periods, hedge funds destroyed wealth because their returns were below the rates of inflation.

Over the last 20 years, hedge funds barely managed to outperform virtually riskless one-year Treasury bills, and they underperformed traditional 60% stock/40% bond portfolios by wide margins.

Hedge fund defenders typically retort that it’s not fair to lump all hedge funds together like this.

And as I note above, it’s certainly true that some funds have delivered extraordinary gains to investors.

However by the same token some individual stocks have done well, and some markets tracked by certain index funds have smashed others.

So that argument doesn’t really hold water for me.

Another push back is that many hedge funds don’t aim to beat the market. Rather they offer diversification and hedging benefits by following alternative strategies.

Again, I’m not massively persuaded – at least not enough to get the whole pseudo-asset class off the hook.

As Nicholas Rabener at Finominal noted recently, hedge funds tend to be more correlated with market downside than the upside – a very undesirable characteristic. In Rabener’s analysis, investment grade bonds offered superior diversification.

Swedroe also shoots down the counterarguments before concluding:

Why have hedge fund assets continued to grow and why have investors ignored the evidence?

One possible explanation is the need by some investors to feel ‘special’, that they are part of ‘the club’ that has access to those funds.

Those investors would have been better served to follow Groucho Marx’s advice: “I wouldn’t want to belong to a club that would have me as a member.”

Another explanation is that investors were not aware of the evidence.

Full disclosure: Buffett’s returns – as represented by the growth in Berkshire’s share price – have slipped in recent years, too.

I mean, as per his 2022 letter Berkshire’s compounded annual gain from 1965 to 2022 is now a mere 19.8%. That’s versus 9.9% for the S&P 500 over the same time period.

(I’m being facetious. Berkshire’s return is bonkers, equivalent to an overall gain of 3,787,464% since 1964.)

How to make $81 million before you’re 40

Returning to Warren Buffett, you might ask why if he’s so smart did he not start a hedge fund instead?

There were plenty of active funds in existence by 1965. Buffett’s first employer, Graham Newman, was essentially a hedge fund.

Well, the answer is – Buffett did!

In the days before Berkshire Hathaway, Warren Buffett ran his partnerships I mentioned along hedge fund lines. 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 fees take no punitive hit in negative years, so Buffett was again doing things differently.

Also, Buffett then did exactly what critics of Smith’s calculations say no hedge fund would really do. He reinvested the fees he drew from his partners back into the partnerships, compounding his 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 $80 million in today’s money. Buffett earned it by the age of 37.

This was how Warren Buffett first got rich.

Don’t bank on finding another Buffett

Buffett’s supreme confidence in his investing techniques and a favourable market meant he never took the downside of his unusual fee structure. 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. That was when he wound the partnerships down and instead lumped his money in with that of his 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 fortunate Buffett didn’t foist 2/20 fees on them. They were made immeasurably wealthier by being on the same terms in Berkshire.

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 long 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 like the plague. Most people should use index funds instead.

(If you don’t believe me, believe Buffett!)

1. Terry Smith has closed his blog where his article was first published. I’ve linked to an Investment Week report on this maths above. [↩]