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2016: Update on Buffett's wager against hedge funds.
WARREN BUFFETT: In a few minutes we’ll break, but I think it almost ties in with this last question.
If we could put slide 3 up.
I promised — some years ago I made a wager — and I promised to report, before the lunch, how the wager was coming out.
And I’ve been doing that regularly, but it probably seems appropriate, since it’s developed this far, to point out a rather obvious lesson, which is what I hoped to drive home, to some degree, by offering to make the wager originally.
Incidentally, when I offered to make the wager, namely that somebody could pick out five hedge funds and I would take the unmanaged S&P index used by Vanguard Fund, and I would bet that over a ten-year period that the unmanaged index would beat these five funds that were all being managed, presumably — they could pick any five funds — that were managed by people who were charging incredible sums to people because of their supposed expertise.
And, fortunately, there’s an organization called, or at least you go — if you go to the Internet, if you put in longbets.org — it’s a terribly interesting website.
You can have a lot of fun with it because people take the opposite side of various propositions that have a long tail to them and make bets as to the outcome, and then they both give their — each side gives their reasons.
And you can go to that website and you can find bets about, you know, whether — what population will be doing 15 years from now or — all kinds of things.
And our bet became quite famous on there. They — and a fellow I like, who I didn’t know before this, Ted Seides, bet that he could pick out five hedge funds — these were funds of funds.
In other words, there was one hedge fund at the top and then that manager picked out who he thought were the best managers underneath, and then bought into these other funds in turn, so that the five funds of funds represent, maybe, 100 or 200 hedge funds underneath.
Now bear in mind that the hedge fund — the fellow making the bet — was picking out funds where the manager on top was getting paid, perhaps, 1/2 percent a year, plus a cut of the profits, for merely picking out who he thought were the best managers underneath, who in turn were getting paid, maybe, 1 1/2 or 2 percent, plus a cut of the funds’ profits.
But certainly the guy at the top was incentivized to try and pick out great funds, and at the next level, those people were presumably incentivized, too.
So the result is, after eight years, and several hundred hedge fund managers being involved, is that now the totally unmanaged fund by Vanguard with very, very minimal costs, is now 40-some points ahead of the group of hedge funds.
Now that may sound like a terrible result for the hedge funds, but it’s not a terrible result for the hedge fund managers. (Laughs)
These managers — A), you’ve got this top-level manager that’s charging probably 1/2 percent, I don’t know that for sure, and down below you’ve got managers that are probably charging 1 1/2 to 2 percent.
So if you have a couple of percentage points sliced off every year, that is a lot of money.
We have two managers at Berkshire that each manage $9 billion for us. They both ran hedge funds before.
If they had a 2-and-20 arrangement with Berkshire, which is not uncommon in the hedge fund world, they would be getting $180 million each, you know, merely for breathing, annually. (Laughter)
That — I mean that — it’s a compensation scheme that is unbelievable to me, and that’s one reason I made this bet.
But what I’d like you to do is for a moment imagine that in this room we have the entire — you people own all of America, all the stocks in America are owned by this group. You are the Berkshire 18,000, or whatever it is, that has someone managed to accumulate all the wealth in the country.
And let’s assume we just divide it down the middle, and on this side we put half the people — half of all the investment capital in the world — and that capital is what a certain presidential candidate might call “low energy.”
In fact, they have no energy at all. They buy half of everything that exists in the investment world, 50 percent, everyone on this side. And so now half of it is owned by these — by these no-energy people.
They don’t look at stock prices. They don’t turn on business channels. They don’t read The Wall Street Journal. They don’t do anything. They just — they are a slovenly group that just sits for year after year after year owning half of the country — half of America’s business.
Now what’s their result going to be? Their result is going to be exactly average, as how America business does, because they own half of all of it. They have no expenses, no nothing.
Now what’s going to happen with the other half? The other half are what we call the “hyperactives.”
And the hyperactives, their gross result is also going to be half, right? They can’t — the whole has to be the sum of the parts here, and this group, by definition, can’t change from its half of the ultimate investment results.
This half is going to have the same gross results — you’re going to have the same results as the low-energy — no-energy people, and they’re also going to have terrific expenses, because they’re all going to be moving around, hiring hedge funds, hiring consultants, paying lots of commissions and everything.
And that half, as a group, has to do worse than this half. The people who don’t do anything have to do better than the people that are trying to do better. It’s that simple.
And I hoped through making this bet to actually create a little example of that, but that offer was open to anybody. And I would make, incidentally, the same offer now except, you know, being around in 10 years to collect gets a little more problematic as we go through life. (Laughs)
But it seems so elementary. But I will guarantee you that no endowment fund, no public pension fund, no extremely rich person, wants to sit in that part of the auditorium.
They just can’t believe that because they have billions of dollars to invest that they can’t go out and hire somebody who will do better than average. I hear from them all the time.
So this group over here, supposedly sophisticated people, generally richer people, hire consultants, and no consultant in the world is going to tell you, just buy an S&P index fund and sit for the next 50 years.
You don’t get to be a consultant that way. And you certainly don’t get an annual fee that way.
So the consultant’s got every motivation in the world to tell you, this year I think we should concentrate more on international stocks, or this year this manager is particularly good on the short side.
And so they come in and they talk for hours, and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in American business without cost.
And then those consultants, after they get their fees, they, in turn, recommend to you other people who charge fees which, as you can see over a period of time, cumulatively eat up capital like crazy.
So, I would suggest that what I felt sure — I didn’t feel sure because nothing — you can’t tell for sure about any 10-year period — but it certainly felt very probable or I wouldn’t have stuck my neck out.
It just demonstrates so dramatically — I’ve talked to huge pension funds, and I’ve taken them through the math, and when I leave, they go out and hire a bunch of consultants and pay them a lot of money. And — it — just unbelievable. And the consultants always change the recommendations a little bit from year to year. They can’t change them 100 percent, because then it didn’t look like they knew what they were doing the year before, so they tweak them from year to year.
And they come in and they have lots of charts and PowerPoint presentations, and they recommend people who, in turn, are going to charge them a lot of money. And they say, well, you can only get the best talent by paying 2-and-20, or something of the sort.
And the flow of money from the hyperactive to what I call the helpers is dramatic, while this group over here sits here and absolutely gets the record of American industry.
So I hope you realize that for most — for the population as a whole — American business has done wonderfully, and the net result of hiring professional management, you know, is a huge minus.
And at the bookstore we have a little book called “Where Are the Customer’s Yachts?” written by Fred Schwed. I read it when I was about 10-years-old. Been updated a few — well it hasn’t been updated, but new editions have been put out a few times — but the basic lessons are there.
That lesson is told in that book from 1940. It’s so obvious, and yet all the commercial push is behind telling you that you ought to think about doing something today that’s different than you did yesterday.
You don’t have to do that. You just have to sit back and let American industry do its job for you.
Charlie, do you have anything to add to my sermon? (Applause)
CHARLIE MUNGER: Well, you’re talking to a bunch of people who have solved their problem by buying Berkshire Hathaway. (Laughter)
That worked even better. And there have been a few of these managers, the managers —
WARREN BUFFETT: Sure.
CHARLIE MUNGER: — who’ve actually succeeded. They are a few in the universities who are really good.
But it’s a tiny group of people. It’s like looking for a needle in a haystack.
WARREN BUFFETT: Yeah. And when I was given the job of naming two in 1969, I knew — I knew two — I knew a couple of others. Charlie wasn’t interested in managing more money then, and my friend Walter Schloss would not scale up well, although he had a fabulous record over 45 years, or thereabouts.
But, you know, that was all I could come up with at that time. And fortunately, you know, I did have a couple. And the people who went with Sequoia Fund have been well-served, if they stayed for the whole period.
But the — the people — there’s been far, far, far more money made by Wall — by people in Wall Street — through salesmanship abilities than through investment abilities.
There are a few people out there who are going to have an outstanding investment record. But there are very few of them, and the people you pay to have identify them don’t know how to identify them. And — and they do know how to sell you. That’s my message.