Jeff Benjamin

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Buffett sitting pretty in hedge fund bet, but strategy leaves much to be desired

Recent history shows why and how diversification and active strategies not only work but are necessary

By Jeff Benjamin

Feb 6, 2014 @ 1:04 pm (Updated 1:41 pm) EST

warren buffett, protege partners, hedge fund, bet, alternatives, liquid alternatives, mutual funds, index funds, etfs
Bloomberg News

Six years into his 10-year performance challenge with a hedge fund shop, Warren E. Buffett is sitting pretty with a formidable total return advantage of 43.8%, to 12.5%.

At first blush, it certainly looks impressive. But let's get real here.

Mr. Buffett, the ridiculously rich chairman of Berkshire Hathaway Inc. who has earned the moniker of Oracle of Omaha, isn't really participating in a fair fight, and he has to know that.

I have no idea what the point of the original wager was between him and the hedge fund shop Protégé Partners beyond the fact that four years from now, the loser will be donating $1 million to a charity of their choosing.

What I do know for sure is that Mr. Buffett, whose wager strategy involves just sitting in the Vanguard 500 Index Admiral Shares Fund (VFIAX), is playing the law of averages that the broad equity market can outperform a much more diversified portfolio of five funds of hedge funds over a 10-year period.

Assuming the stock market sheds some of the recent volatility, his bet might actually pay off. But aside from underscoring the advantage of pitting one of the least expensive index funds on the market against the multiple layers of fees at Protégé, nobody could take such an investment strategy seriously.

On a total return basis over a relatively short period, it is easy to deny the benefits of diversification through alternative strategies.

The past five-, three- and one-year periods have offered a near-perfect picture of why and how diversification and active strategies not only work but are necessary.

“We've gone through a bear market, a bull market and what I would call a volatile market last year, which is the start of the kind of interest rate volatility we'll probably be seeing for the next several years,” said Mark Okada, co-founder and chief investment officer of Highland Capital Management.

Highland, which has nearly $19 billion under management in various alternative strategies, started moving into registered liquid alternative products such as mutual funds and exchange-traded funds a decade ago.

Although specific data are difficult to come by, it appears that Mr. Buffett's index fund lagged his hedge fund opponent for at least the first four years of the wager period. The all-equity strategy only started pulling away the past few years, but at this point that advantage looks to be in jeopardy.

“On a headline basis, alternatives haven't gotten a lot of attention lately, but if you can slice it into a risk-adjusted basis, you can see why advisers should always be allocating to alternatives,” Mr. Okada said.

“Look at where volatility has moved over the last six months, with a pickup especially this year," he said. "If you think of that as the environment we're going to have for next several years, then alternatives become so much more valuable.”

As one of the world's wealthiest individuals, Mr. Buffett certainly can afford to place million-dollar bets for fun. But regardless of the point or outcome of this wager, the financial services industry is astutely moving beyond such folly.

A November survey of investors with a net worth of at least $1 million found that a third were already investing in alternative strategies.

The survey, conducted by Mainstay Investments, found that the average period invested in alternatives was more than eight years and the average portfolio allocation to alternatives was 22%.

Although the term alternative has some risky — and negative — connotations, the Mainstay research found that 60% of investors in alternatives are doing so to protect principal, not to speculate.

And investors are increasingly accessing alternative strategies through traditional and liquid vehicles such as mutual funds (65%), ETFs (40%) and managed accounts (38%).

“The key for us is really seeing the growth of alternatives as becoming the new normal,” said Matt Leung, head of channel marketing strategy at Mainstay.

“Traditional style boxes tend to stay in quadrants but when you look at the alternative environment, investors are exposed to more global strategies,” he said, underscoring the diversification benefits.

The movement is such that there now are projections that completely rewrite traditional portfolio building strategies.

A November report from money management consulting and research firm Casey Quirk & Associates went a few steps beyond what we know as alternatives to the notion of retooling active management.

The study highlighted six categories of new active strategies that are likely to reshape portfolio construction over the next few years.

The categories are broad debt investments, benchmark-agnostic equity, private-capital strategies, trading strategies, dynamic multiasset class solutions and real asset platforms. Such is the new alternative landscape or at least part of it.

The idea is that investors' needs and market cycles will have to move investments away from rigid benchmark-based allocations toward risk factor and outcome-based mandates, according to the study.

The research also predicts that these new active alternatives will attract $3.4 trillion of inflows through 2018, while legacy portfolios will lose more than $1.8 trillion.

Passive strategies, meanwhile, are projected to attract $1 trillion during the same time period.

“People are looking for outcome-based solutions, versus the cheapest way to lose money, which is what index funds showed them in 2008,” said Mike Dieschbourg, senior vice president and managing director of alternatives and managed accounts at Federated Investors.

Hats off to Mr. Buffett for proving that over a six-year period an all-stock index can beat a diversified hedging strategy.

But all it really proves is that both strategies belong in a portfolio.