Buffett's hedge fund strategy leaves much to be desired

Active strategies, diversification work and are necessary

Feb 16, 2014 @ 12:01 am

By Jeff Benjamin

warren buffett, hedge fund, bet, active, passive, index, protege partners
+ Zoom
(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, the benefits of diversification through alternative strategies don't always make themselves clear.

DIFFERENT MARKETS

However, 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.

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 are 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 accessing alternative strategies increasingly 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.

NEW PROJECTIONS

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

A November report from money management consulting and re-search 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 in 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.

0
Comments

What do you think?

View comments

Recommended for you

Sponsored financial news

Upcoming Event

May 31

Conference

Spring Excell—Peak Advisor Alliance

Members of the InvestmentNews Research team will be presenting new adviser benchmarking data and providing strategies that can help accelerate the growth of your business. In this exclusive three-hour workshop, InvestmentNews will... Learn more

Featured video

INTV

Advisor Group's Jamie Price: The real reason why most advisers don't have a succession plan in place

Eighty percent of advisers do not have a succession plan in place, though about half of them already know they will need to transition their businesses within the next 10 years, according to Jamie Price, president and CEO of Advisor Group.

Latest news & opinion

The appeal and pitfalls of holding unconventional assets in retirement accounts

While non-traditional asset classes held in individual retirement accounts may have return and portfolio diversification benefits, there are "unique complexities" that limit their value for most investors.

Wells Fargo's move to boost signing bonuses could give it a lift

Wirehouse is seen as trying to shore up adviser ranks that took a hit after banking scandal

New Jersey fines David Lerner Associates for nontraded REIT sales

Firm will pay $650,000 for suitability, compliance and books and records violations.

Report predicts $400 trillion retirement savings gap by 2050

Shortfall driven by longer life spans and disappointing investment returns.

Wells Fargo will ramp up spending to lure brokers

Wirehouse, after losing 400 brokers in first quarter, is bucking trend among rivals who have said they are going to cut back on spending big bucks recruiting veteran advisers

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print