Who makes the most money in the USA? Probably CEOs and Hedge Fund managers. Probably more 'smart' individuals have made more money on Wall Street than using their brains in inventing products or setting up real businesses employing hundreds or thousands of employees.
Now, do you know how smart these smarty pants are? Actually, the majority of them are no smart. It is generally hype and propaganda. They take in millions of dollars in profits by charging 2/20%! Don't take my words or opinions on this but see what Warren Buffett actually proved in his famous $500000 bet in 2007-2008! I found this very interesting piece while reading his famous letter to Berkshire Hathaway shareholders. It is a long letter on the link below. You should read it if you invest in stocks. However, if you are too busy, read the Copy and Paste of his write up below:
http://www.berkshirehathaway.com/letters/2016ltr.pdf
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Now, to my bet and its history. In Berkshire’s 2005 annual report, I argued that active investment
management by professionals – in aggregate – would over a period of years underperform the returns achieved by
rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave
their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index
fund. (See pages 114 - 115 for a reprint of the argument as I originally stated it in the 2005 report.)
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 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. He has been both straightforward with me and meticulous in supplying all the data that both he
and I have needed to monitor the bet.
For Protégé Partners’ side of our ten-year bet, Ted picked five fund-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.
Each fund-of-fund, of course, operated with a layer of fees that sat above the fees charged by the hedge
funds in which it had invested. In this doubling-up arrangement, the larger fees were levied by the underlying
hedge funds; each of the fund-of-funds imposed an additional fee for its presumed skills in selecting hedge-fund
managers.
Here are the results for the first nine years of the bet – figures leaving no doubt that Girls Inc. of Omaha,
the charitable beneficiary I designated to get any bet winnings I earned, will be the organization eagerly opening
the mail next January.
Footnote: Under my agreement with Protégé Partners, the names of these funds-of-funds have never
been publicly disclosed. I, however, see their annual audits.
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.
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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).
Here is what I asserted:
Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017,
the S&P 500 will outperform a portfolio of funds of hedge funds when performance is
measured on a basis net of fees, costs, and expenses.
A lot of very smart people set out to do better than average in securities markets. Call them
active investors.
Their opposites, passive investors, will by definition do about average. In aggregate their
positions will more or less approximate those of an index fund. Therefore, the balance of
the universe—the active investors—must do about average as well. However, these
investors will incur far greater costs. So, on balance, their aggregate results after these costs
will be worse than those of the passive investors.
Costs skyrocket when large annual fees, large performance fees, and active trading costs are
all added to the active investor’s equation. Funds of hedge funds accentuate this cost
problem because their fees are superimposed on the large fees charged by the hedge funds
in which the funds of funds are invested.
A number of smart people are involved in running hedge funds. But to a great extent, their
efforts are self-neutralizing, and their IQ will not overcome the costs they impose on
investors. Investors, on average and over time, will do better with a low-cost index fund
than with a group of funds of funds.
So that was my argument – and now let me put it into a simple equation. If Group A (active investors)
and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average
results before costs, so, too, must A. Whichever group has the lower costs will win. (The academic in me requires
me to mention that there is a very minor point – not worth detailing – that slightly modifies this formulation.)
And if Group A has exorbitant costs, its shortfall will be substantial.
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. Bill Ruane – a truly wonderful human
being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the
long haul – said it well: “In investment management, the progression is from the innovators to the imitators to the
swarming incompetents.”
Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that
some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make
a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine
consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet.
But there would remain a difference: The lucky monkey would not find people standing in line to invest with
him.
Finally, there are three connected realities that cause investing success to breed failure. First, a good
record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment
performance: What is easy with millions, struggles with billions (sob!). Third, most managers will nevertheless
seek new money because of their personal equation – namely, the more funds they have under management, the
more their fees.
These three points are hardly new ground for me: In January 1966, when I was managing $44 million, I
wrote my limited partners: “I feel the substantially greater size is more likely to harm future results than to help
them. This might not be true for my own personal results, but it is likely to be true for your results. Therefore, . . .
I intend to admit no additional partners to BPL. I have notified Susie that if we have any more children, it is up to
her to find some other partnership for them.”
The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will
usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick
with low-cost index funds.
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