Are you jealous of the billions of dollars those fat cats and their hedge funds are raking in while you struggle just to fill your car with gas? Don't be so sure that the fat cats aren't the suckers. Warren Buffett thinks hedge funds are basically a scam on the wealthy.

Will a collection of hedge funds, carefully selected by experts, return more to investors over the next 10 years than the S&P 500?

That question is now the subject of a bet between Warren Buffett, the CEO of Berkshire Hathaway, and Protégé Partners LLC, a New York City money management firm that runs funds of hedge funds - in other words, a firm whose existence rests on its ability to put its clients' money into the best hedge funds and keep it out of the underperformers. ...

We're way past theory here. This bet, being reported for the first time in this article (whose author is both a longtime friend of Buffett's and editor of his chairman's letter in the Berkshire annual report), has been in existence since Jan. 1 of this year.

It's between Buffett (not Berkshire) and Protégé (the firm, not its funds). And there's serious money at stake. Each side put up roughly $320,000. The total funds of about $640,000 were used to buy a zero-coupon Treasury bond that will be worth $1 million at the bet's conclusion.

My money's on the S&P 500. Let's take a look at the steep hill the hedge funds have to climb:

As for the fees that investors pay in the hedge fund world - and that, of course, is the crux of Buffett's argument - they are both complicated and costly.

A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones "bought" by Buffett in the bet.

On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the "helpers" that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

When you add up all those fees, Buffett thinks the super-rich would be better off investing like the rest of us non-Buffetts: in no-load, low-expense index funds.

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