Streetwise for Friday, November 10, 2017

I continue to receive questions asking about the efficacy of investing in what are called alternative investments as part of a diversification strategy. Alternative investments are part and parcel of what is called modern portfolio theory. The theory calls for a portfolio to be diversified into different uncorrelated investments.

Alternative investments are one such a category that includes hedge and private equity funds. I am not in favor of such investments, especially for the average investor, and I am not alone.

Warren Buffett has long been a critic of so-called alternative investing, calling it, “A fool’s game.” The reason is the fees the managers of those investments take for their services. Typically, hedge fund fees are typically two percent plus an incentive, or “carry,” of 20 percent of the profits. The result is billions of dollars for the managers and far less for clients.

In a letter to Berkshire Hathaway shareholders. Buffett wrote that many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers who, in turn, recommend other high-fee managers, labeling it a fool’s game.

The players in this “fool’s game,” include not only wealthy individuals but also mutual funds, pension funds, university endowments, foundations and even sovereign wealth funds managed on behalf of countries.

AS I wrote last year, Buffett made his point with hard cash in his famous “Million-Dollar Bet,” with hedge fund-focused investment firm Protégé Partners. The bet was that an S&P 500 index fund would beat a mix of five funds that utilized hedge funds over a period of 10 years.

After eight years, Buffett gloated at his annual meeting in Omaha, Nebraska, that his selection of the Vanguard 500 Index Fund was up 65.67 percent; Protégé’s fund of funds was up a paltry 21.87 percent.

Although the contest was scheduled to run through December of this year, Buffett has won the bet, Ted Seides wrote in a Bloomberg op-ed this past May. The Protégé co-founder, who left in the fund in 2015, conceded defeat ahead of the contest’s scheduled end, writing that, “for all intents and purposes, the game is over. I lost.”

Buffett’s victory was not always certain. Soon after the wager began on January 1, 2008, the equity markets tanked, and the hedge funds were able to show off the strength of their hedging decisions. Buffett’s index fund lost 37 percent of its value, compared to the hedge fund’s 23.9 percent.

From that point on, Buffett was ahead of Protégé every year from 2009 through 2014. However, it took four years to pull ahead of the hedge funds in terms of cumulative return.

In 2015, Buffett lagged his hedge fund rival for the first time since 2008, gaining 1.4 percent versus Protégé’s 1.7 percent. However, 2016 saw Buffett gain 11.9 percent to Protégé’s 0.9 percent. At the end of 2016, Buffett’s index fund gained 7.1 percent per year, or $854,000 in total, compared to 2.2 percent per year or $220,000 for Protégé.

In his shareholder letter, Buffett said he believed the hedge fund managers involved in the bet were “honest and intelligent people,” but added, “the results for their investors were dismal – really dismal.”

Buffett also pointed out that the two-and-twenty fee structure means that managers were “showered with compensation” despite, often enough, providing only “esoteric gibberish” in return.

In the end, Seides admitted the strength of Buffett’s argument: “He is correct that hedge-fund fees are high, and his reasoning is convincing. Fees matter in investing, no doubt about it.” However, Seides did push back against some of the Berkshire CEO’s passive triumphalism.

“Fees will always matter,” he wrote, “but market risk sometimes matters more.” The S&P 500’s run-up following the financial crisis defied reasonable expectations, Seides argued.

The charity of the winner’s choice will receive $1 million or more at the bet’s end. The money, held by the Long Now Foundation, has not assigned victory to one party or the other; despite Seides’ admission of defeat.

Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.