(Image: Zen Buddha Silence by Marilyn Barbone.)
July 23, 2017
Warren Buffett has long maintained that most investors—large and small—would be best off by simply investing in ultra-low-cost index funds. Buffett explains his reasoning again in the 2016 Letter to Berkshire Shareholders (see pages 21-25): http://berkshirehathaway.com/letters/2016ltr.pdf
Passive investors will essentially match the market over time. So, argues Buffett, active investors will match the market over time before costs (including fees and expenses). After costs, active investors will, in aggregate, trail the market by the total amount of costs. Thus, the net returns of most active investors will trail the market over time. Buffett:
There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified—early on—only ten or so professionals that I expected would accomplish this feat.
There are no doubt many hundreds of people—perhaps thousands—whom I have never met and whose abilities would equal those of the people I’ve identified. The job, after all, is not impossible. The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.
As for those active managers who produce a solid record over 5-10 years, many of them will have had a fair amount of luck. Moreover, good records attract assets under management. But large sums are always a drag on performance.
BUFFETT’S BET AGAINST PROTÉGÉ PARTNERS
Long Bets is a non-profit started by Jeff Bezos. As Buffett describes in his 2016 Letter to Shareholders, “proposers” can post a proposition at www.Longbets.org that will be proved right or wrong at some date in the future. They wait for someone to take the other side of the bet. Each side names a charity that will be the beneficiary if its side wins and writes a brief essay defending its position.
Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds—wildly-popular and high-fee investing vehicles—that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers—who could include their own fund as one of the five—to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?
What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man—Ted Seides—stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds—in other words, a fund that invests in multiple hedge funds.
I hadn’t known Ted before our wager, but I like him and admire his willingness to put his money where his mouth was…
For Protégé Partners’ side of our ten-year bet, Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager.
Here are the results so far after nine years (from 2008 thru 2016):
|Net return after 9 years|
|Fund of Funds A||8.7%|
|Fund of Funds B||28.3%|
|Fund of Funds C||62.8%|
|Fund of Funds D||2.9%|
|Fund of Funds E||7.5%|
|Net return after 9 years|
|S&P 500 Index Fund||85.4%|
|Compound Annual Return|
|All Funds of Funds||2.2%|
|S&P 500 Index Fund||7.1%|
To see a more detailed table of the results, go to page 22 of the Berkshire 2016 Letter: http://berkshirehathaway.com/letters/2016ltr.pdf
The compounded annual increase to date for the index fund is 7.1%, which is a return that could easily prove typical for the stock market over time. That’s an important fact: A particularly weak nine years for the market over the lifetime of this bet would have probably helped the relative performance of the hedge funds, because many hold large ‘short’ positions. Conversely, nine years of exceptionally high returns from stocks would have provided a tailwind for index funds.
Instead we operated in what I would call a ‘neutral’ environment. In it, the five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000.
Bear in mind that every one of the 100-plus managers of the underlying hedge funds had a huge financial incentive to do his or her best. Moreover, the five funds-of-funds managers that Ted selected were similarly incentivized to select the best hedge-fund managers possible because the five were entitled to performance fees based on the results of the underlying funds.
I’m certain that in almost all cases the managers at both levels were honest and intelligent people. But the results for their investors were dismal—really dismal. And, alas, the huge fixed fees charged by all of the funds and funds-of-funds involved—fees that were totally unwarranted by performance—were such that their managers were showered with compensation over the nine years that have passed. As Gordon Gekko might have put it: ‘Fees never sleep.’
The underlying hedge-fund managers in our bet received payments from their limited partners that likely averaged a bit under the prevailing hedge-fund standard of ‘2 and 20,’ meaning a 2% annual fixed fee, payable even when losses are huge, and 20% of profits with no clawback (if good years were followed by bad ones). Under this lopsided arrangement, a hedge fund operator’s ability to simply pile up assets under management has made many of these managers extraordinarily rich, even as their investments have performed poorly.
Still, we’re not through with fees. Remember, there were the fund-of-funds managers to be fed as well. These managers received an additional fixed amount that was usually set at 1% of assets. Then, despite the terrible overall record of the five funds-of-funds, some experienced a few good years and collected ‘performance’ fees. Consequently, I estimate that over the nine-year period roughly 60%—gulp!—of all gains achieved by the five funds-of-funds were diverted to the two levels of managers. That was their misbegotten reward for accomplishing something far short of what their many hundreds of limited partners could have effortlessly—and with virtually no cost—achieved on their own.
In my opinion, the disappointing results for hedge-fund investors that this bet exposed are almost certain to recur in the future. I laid out my reasons for that belief in a statement that was posted on the Long Bets website when the bet commenced (and that is still posted there)…
Even if you take the smartest 10% of all active investors, most of them will trail the market, net of costs, over the course of a decade or two. Most investors (even the smartest) who think they can beat the market are wrong. Buffett’s bet against Protégé Partners is yet another example of this.
BUFFETT PRAISES BOGLE
If a statue is ever erected to honor the person who has done the most for American investors, the handsdown choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing—or, as in our bet, less than nothing—of added value.
In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: email@example.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.