2001: Why did Buffett start an investment partnership instead of a mutual fund?

AUDIENCE MEMBER: Michael Wong (PH), San Diego, California. First of all, I would like to thank both of you.

My question is, when you started your business, why you started an investment partnership instead of a mutual fund?

And also, can you recommend a good book, or books, regarding how to start an investment partnership fund and how to service clients, et cetera?

WARREN BUFFETT: Yeah, I don’t know of any books on starting partnerships or hedge funds. Do you know, Charlie?

CHARLIE MUNGER: No, but people seem to manage to create them without the books. (Laughter)

The incentives are awesome.

WARREN BUFFETT: Yes. And the one thing, I mean, it’s always interesting to both of us how you get certain things that are fashionable. And people think that by naming something a given name, that somehow that makes everybody smarter or able to make money in it.

I mean, there is no magic to private equity funds, international investing, hedge funds — all of the baloney that gets promoted in Wall Street.

What happens is that certain things become very promotable, usually because there’s been recent successes by other people, and that the new entrants extrapolate the successes of a few people in the past to promote new money from people currently.

So, they adopt titles that, you know, that they think will attract money and they — but it doesn’t make anybody any smarter if they hang out a shingle in front of their house that says, “hedge fund” or they have a shingle that says “asset allocation firm” or something of the sort. The form doesn’t create talent.

I backed into the business. I mean, I’d worked for a mutual fund — closed-end investment company. In fact, there’s a fellow here today who’s a friend of mine that — the two of us worked there, and we were 40 percent of the whole company because there were three other people, all of whom outranked us considerably. And that firm was Graham-Newman Corp, from 1954 to 1956.

And it was a regulated investment company. It was about $6 million in assets, which seemed like a big deal at the time. And Ben Graham was one of the best known investors in the world, and he had $6 million in his fund.

There was a sister partnership called Newman and Graham, which operated in what would, today, be called “hedge fund style,” as far as a partnership split of the profits and so on.

And when I left there in ’56 and I came back here, we had seven people, a couple of whom are here in the room, who said, “Do you want to manage money?” And I said, “Well, here’s what I learned at Graham-Newman,” that Newman and Graham is a better way to do it than Graham-Newman.

So I formed a little partnership, and then I met Charlie a few years later. And he figured, if I was making money doing it, he’d make a lot more. So — (laughter) — he formed one. And that was the carefully calculated strategy of how we both became involved in the partnership business.

Charlie? (Laughs)

CHARLIE MUNGER: Yeah, it is amazing how big the hedge fund industry has become. They have conventions on the subject now. And in the late ’20s, you could take a course on how to run a crooked security pool.

And these things come in great waves. I’m not suggesting the hedge funds are crooked, but I am suggesting that you get these waves of fashion that go to great extremes. The amount of money, what is it now, Warren, in hedge funds?

WARREN BUFFETT: It’s very big, although it’s a little less in a few quarters than it used to be. (Laughs)

But I would be willing to put a lot of money up that if you take the aggregate experience of all the hedge funds — as starting right today and going for the next 15 years — I would bet a lot of money it will not hit 10 percent, in terms of return to partners. And I would, if you push me, I would bet at a lower figure than that.

CHARLIE MUNGER: Then you have Bernie Cornfeld’s idea, the Fund of Funds. There are people who want to get paid for selecting hedge funds for other people. And that didn’t work very well for Bernie Cornfeld.

WARREN BUFFETT: Well, it worked pretty well for Bernie for a while, but it didn’t work so well for his investors, actually. (Laughter)

Yeah. That result was probably something Bernie had in mind at the start maybe.