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The Warren Buffett hedge fund that wasn’t

Photo of 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 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. []
{ 17 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 with the thinking as a company owner. Shame it’s such a bugger to replicate 😉

  • 2 OldPro October 9, 2010, 8:22 pm

    Its often seemed odd to me how Buffett let 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!

  • 3 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.

  • 4 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).

  • 5 trufflehunt April 27, 2023, 6:16 pm

    For me, the big lessons I’ve learned from Warren Buffet are…

    1. Some of his views on life, and how to live it.

    2. Noting that with Berkshire Hathaway, he has done what professional traders do, (or ought to do)…, that is managing the downside risk. He transformed Berkshire, after lots of years of trying to make it work, from a textiles manufacturer into a holding company of insurers. Insurance companies generate lots of cash , from premiums, with the downsides, claims, only coming much later ( assuming your risk assesors are up to the job). He used the upfront cash to invest further.

  • 6 Ramzez April 27, 2023, 10:40 pm

    I guess you can just always buy Berkshire stock and treat it as fund with 0% fees. It doesn’t pay dividend but capital gain can be great?

  • 7 xxd09 April 27, 2023, 11:33 pm

    2 lessons on fees standout for me amongst many others in my progress to manage my own money
    1) An investment in a pension wrapper run by a large insurance company (I was a 40% taxpayer at the time ) and using the same fund also at the same time in a general investment account
    The same end result occurred ie the insurance company was taking all my 40% tax relief as expenses for running a pension wrapper!
    2) a fatally honest IFA who gave a graph to me of the cost to me of his expenses over a 30+ investment period of my investment pot
    He ended up with almost the same as me !
    I remarked to my wife that I could do it all myself ,make a few errors and still come out ahead
    Those were the bad old days -things are better now but investors need to be constantly vigilant on costs-it financially well worth it

  • 8 Fage April 28, 2023, 10:46 am

    It’s a long time since I was an actuary, so I don’t pretend to be an expert on finance. Nonetheless, the attitude that I’m being stupid to invest in hedge funds aggravates me. Many that say this seem to have done less research than I have.

    I don’t agree with your view that we should lump all hedge funds together. I don’t lump bonds and equities together so why would I lump equity long-short with macro? It’s also not reasonable to compare an investment with a much lower volatility to one with a vastly higher volatility like stocks.

    I’ve been investing money since 2000 or so and US equities have delivered around 6.5%/annum in that time with a volatility of 18%. Longer duration UST treasuries around 5.5%/annum with a volatility of 13%, both measured in US dollars. The numbers you’ve quoted from Swedro conveniently ignore the 2000-02 drawdown where I lost a rather painful 40%.

    By comparison a few segments of the hedge fund industry do offer something that equities and bonds struggle to match. Based on EurekaHedge indices, macro hedge funds have delivered around 7.6%/annum since 2000 with a volatility of 4% (http://www.eurekahedge.com/Indices/IndexView/Eurekahedge/481/Eurekahedge-Macro-Hedge-Fund-Index). CTA trend following funds 8.6% with 6.1% volatility. Multi-managers 8.3% with 4.8% volatility.

    I’m currently close to retirement so I tend more to deaccumulation than accumulation. The volatility of equities is too high to have a big weighting. Bonds only work in certain environments. Gold the same. I’ve found a portfolio of hedge funds has really helped to lower my drawdowns in the last 5 years or so whilst still earning decent positive returns. They perform well when volatility is high and conventional assets are getting hammered. What I like though is the funds I own don’t invest at all. They just trade. So, I capture a lot of mean-reversion.

    You clearly have the problem that you cannot buy the index. So, I agree it’s like stock picking and that is rather difficult. I haven’t found initial access a problem. Most seemed to accept investments as low as $250k or so. The problem is I’ve gone to invest new money and there now seems to be a waiting list, or they are closed. They seem far more popular now than a few years ago which is clearly a concern.

    Nonetheless I’m going to keep some because I feel the environment is much more like the 2000s than the 2010s. It’s not clear to me than conventional assets are going anywhere fast.

  • 9 The Investor April 28, 2023, 12:08 pm

    @Fage — I have nothing against anyone investing in anything that works for them. And I point out in the article that some minority of funds – typically gated, alas – have done very well. Some insanely well even after fees. (Renaissance’s flagship fund, most famously). Similarly, the macro/CTA performance has been brought up many times as a counter.

    However the fact is something like $3 trillion is invested in aggregate in hedge funds, and in aggregate the performance is woeful. That you have alighted on a winner or two doesn’t refute that reality.

    Moreover, even with the superior performance of macro/CTA funds as I’m sure you’re aware you have to think about (a) survivorship bias and (b) again, access.

    Rubbish hedge funds are closed down and they and their rubbish returns leave the index, which if it’s like any other such track record will hugely flatter the picture of what the typical invested $ would have received.

    Secondly, as you rightly flag, access. A handful of huge and successful hedge funds (e.g. Medallion) may be putting up great numbers. But if we can’t invest in them, so what? Meanwhile they will presumably pull up index-level returns. At least some of the successful funds become family offices and entirely closed.

    I am no expert on return-crunching (unlike say Swedroe, who I cite) but I am confident that an ‘investable’ index would not feature such attractive figures.

    Again, I have absolutely zero problem with anyone investing how they like. If you’ve found something that works for you, that’s great, more power to you.

    But the aggregate figures speak for themselves, IMHO, even more so when compounded with the other issues I mention, so the best *general advice* is clearly to avoid the things.

  • 10 Hak April 28, 2023, 12:29 pm

    Interesting analysis. Thank you.

  • 11 Alan Points April 28, 2023, 1:35 pm

    Fage – Good luck with your choices, I’m glad they are working out for you.

    I would suggest though that funds which “accept investments as low as £250k or so” are, to all intents and purposes, closed to the vast majority.

    Even those who follow this blog and are rich as a result

  • 12 xxd09 April 28, 2023, 7:01 pm

    It would be interesting to know how many Monevator blog readers actually use hedge funds-not very many I would imagine!

  • 13 David J Merkel April 28, 2023, 8:02 pm

    This is not a good article. Buffett would have continued his hedge funds if he could have done so. There were three reasons why he chose to close down his funds. 1) High valuations of stocks generally. 2) Lack of stupid cheap stocks to buy (cigar butts). 3) Too much money poured into an underperforming set of companies, particularly Berkshire Hathaway, the textiles company. (And that dud of a department store in Baltimore…)

    Now give Buffett some credit. He closed down his funds because of the lack of future promise, and the desire to make something better out of bad investments. And he succeeded dramatically. His success has little to do with the corporate form that he used, leaving aside one thing, which you did not mention.

    Using insurance companies with low underwriting leverage and relatively long liabilities to own stocks and whole companies was genius. Make money on underwriting and investing, starting with National Indemnity… that was the key difference.

  • 14 The Investor April 29, 2023, 11:07 am

    @David — It might not be a good article, but you appear to be criticizing it for what it’s not. 🙂 This isn’t a deep exploration on how Berkshire Hathaway delivered its returns. It’s a discussion about the striking contrast with the fees charged by hedge funds.

    On your point about float (last paragraph) of course as is well-understood this was key, but it’s also germane in that some high-profile hedge fund managers have indeed tried to create insurance arms to capture investable capital in this way (e.g. Greenlight and Third Point) and as far as I’m aware it’s been a bit of a failure too.

    Cheers for commenting, I’ve enjoyed and linked to several of your articles over the years.

  • 15 Sparschwein April 30, 2023, 10:14 am

    I’d agree with the article as far as hedge funds *that invest in stocks* go.
    This includes equity long/short which has on average a high correlation with stock markets, despite the “short” component.

    But it makes no sense at all to lump stock-based strategies, debt/FI, Macro and Trend all together and draw sweeping conclusions. These are different asset classes, with different risks and correlations and different purposes in a portfolio.

    Macro and Trend tend to be uncorrelated or anticorrelated with stocks, which makes them interesting as a diversifier. They should be judged on their own merits and compared with other options for diversifying both stock market and duration risk. Of which there are precious few.

  • 16 The Investor April 30, 2023, 5:13 pm

    @Sparschwein — I agree that’s the marketing message. I am not so convinced those funds — especially those accessible to most people — are compelling anyway.

    Here’s a comparison for you: https://insights.finominal.com/research-downside-betas-vs-downside-correlations/

    Again, happy to agree some individual funds have their merits, if you can invest in then. (And I currently hold and currently plan to keep holding BHMG bought on a discount in its recent capital raise, FWIW. I also own Pershing Square Trust, which is basically Ackman’s hedge fund as a listed vehicle (on a huge discount)).

    I’m not dogmatic. But I’m also not at all convinced by more granular looks at the hedge fund sector. It’s what people tend to say when they know a bit more but still don’t know enough IMHO. (Just a generalization, and clearly there are people with immense domain knowledge who are very well able to navigate this landscape. But equally there are countless clueless pension fund and endowment boards who’ve underperformed for many years.)

    Even if we look just at long/short equity equity hedge funds / other stock/bond exposed hedge funds, they dwarf the AUM in macro:


    So again the argument basically stands: equity-focused hedge funds comprise the largest portion of assets and have underperformed horribly, despite and perhaps because of charging through the nose. Talking about macro hedge funds in response is chaff is far as I’m concerned re: the main argument against the asset class.

    Again, anyone free to do anything the feel they can on an individual level and if you can find alpha/edge here more power to you. 🙂

  • 17 Rishit Jain, CFA May 2, 2023, 3:03 pm

    Nothing to take away from the main thrust of the article, but Warren Buffett himself has underperformed the S&P 500 for the last 20 years.


    More reason to simply pick index funds.

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