The Sunday Times 18 March 2018
Warren Buffett’s annual letter to shareholders is one of the most widely read dispatches in the business world. Buffett’s insights, expressed with his trademark clarity and humour, are a veritable bounty for the amateur investor. This year did not disappoint.
December 2017 marked the end of a 10-year bet Buffett waged with a hedge fund firm Protégé Partners. And the bet was this:
Each gets to choose an investment for a 10-year period and the best performer commits to pay the other $500,000 (so a total pot of $1m to be donated to a charity of the winner’s choice).
Buffett’s pick was a low cost investment in an unmanaged S&P 500 index fund. Protégé Partners, picked five “fund-of-funds”. Those fund-of-funds in turn owned interests in more than 200 hedge funds.
Let’s cast our mind back to December 2007. The housing crisis in the US had already started and the early signs of stress in the banking sector had begun to appear. The run on Northern Rock in the UK was the previous September. At the time of the bet, it looked like an active approach was the right call. A static bet on the US stock market that had been on a tear since October 2002 looked almost naiive.
The managers of the five fund-of-funds possessed a further advantage: They could – and did – rearrange their portfolios of hedge funds during the ten years, adding better funds while exiting those hedge funds it deemed unworthy.
So how did it pan out?
The hedge funds got off to a good start, each beating Buffett’s index fund in 2008. Then, as Buffett says, “the roof fell in”. In every one of the nine years that followed, the fund-of-funds as a whole trailed the index fund. Result: Buffett +125%; Protégé +36%.
Many of the investors in the hedge funds experienced a lost decade, though not the managers. As Buffett quips, “Performance comes, performance goes. Fees never falter.”
I’m not naiive enough to think that one bet for a single ten year period allows one to draw much by way of conclusion, but Buffett has been highlighting the following lessons for over half a century now.
Lesson #1: A low cost, low turnover approach won out. Despite great resources and even greater incentives to perform, the actively managed approach came up well short. An investor would have needed a fair dose of fortitude to withstand the early losses but it is ever thus with stock markets.
Originally, Protégé and Buffett each funded their portion of the ultimate $1 million prize by purchasing zero coupon U.S. Treasuries at an equivalent yield of 4.56% - so in effect they only had to part with $318,250, knowing that after 10 years this would compound up to $500,000.
By November 2012, the bonds they bought had increased significantly in price and the yield (which moves inversely to the price) had declined to less than 1%. The cash return from dividends on the S&P 500 at the same time was 2.5% annually, about triple the yield on their bonds and with a long history of growing from year to year.
Protégé and Buffett agreed to sell the bonds in 2012 and use the proceeds to buy 11,200 Berkshire “B” shares. The result: more than $2.2m was donated to charity rather than the $1 million they had originally pledged.
And this is lesson #2. Buffett has long been disparaging of the academic view of risk, which equates it to volatility or the dispersion of returns. In Buffett’s view investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that you fail to meet this objective.
We tend to think about money in nominal terms – euros and cents in our bank account. In no long term sense is this money. In the long run, the only rational definition of money is purchasing power. If my living costs double and my capital and interest thereon remain the same, I have lost half my money. If money is purchasing power, risk then becomes that which threatens it and safety that which preserves or enhances it.
Buffett’s switch in 2012 from bonds to equities would be categorised by an academic as having increased his risk; outside of the walls of academia, this makes little sense.
The final lesson from the Buffett bet is the advantage conferred to those that eschew activity with their investments. Buffett made one decision in the ten years. The 200-plus hedge-fund managers that were involved almost certainly made thousands of buy and sell decisions. I’m not drawing a line of causation from a simple do nothing approach to easy riches, but there is undeniable correlation.
I long ago realised I’m no Warren Buffett. But you don’t have to be a genius to see the profit in applying the simple lessons from his bet.
Gary Connolly is Managing Director of iCubed. He can be contacted at firstname.lastname@example.org or on twitter @gconno1. iCubed Training, Research and Consulting, trading as iCubed, is regulated by the Central Bank of Ireland.