Warren Buffett (Trades, Portfolio) published his annual letter to shareholders of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) at the end of last month. As usual, it contains plenty of interesting information for both shareholders and general readers alike.
This year, in addition to the usual commentary on how Berkshire Hathaway performed throughout 2017, he also went on to give an interesting perspective on fees and the impact they have on investment performance. This discussion also contains a compelling underlying message about the drawbacks of diversification.
The bet
In 2007, Buffett made a bet with Protégé Partners that over the long term, a period of 10 years, a simple investment in the S&P 500 would beat a selection of hedge funds. Protégé picked “funds-of-funds” it expected to outperform the S&P 500. Each of these funds, in turn, owned interests in more than 200 hedge funds, giving exposure to around 1,000 hedge fund managers in total. Surely, this collection of Wall Street's brightest minds could easily outperform the wider market. As Buffett wrote in his letter:
"Essentially, Protégé, an advisory firm that knew its way around Wall Street, selected five investment experts who, in turn, employed several hundred other investment experts, each managing his or her own hedge fund. This assemblage was an elite crew, loaded with brains, adrenaline, and confidence."
Not only did Protégé have the advantage of 1,000 of the brightest minds on Wall Street on its side, but its managers were also highly incentivized to outperform. Those that did not could easily be swapped out for a new fund that was beating the market.
"The managers of the five funds-of-funds possessed a further advantage: They could – and did – rearrange their portfolios of hedge funds during the ten years, investing with new 'stars' while exiting their positions in hedge funds whose managers had lost their touch."
The problem is these hedge funds collect fees no matter the market environment. If the market had moved nowhere in 10 years, they still would have picked up a 2% management fee and 20% on any profits, which means to generate a positive return they would have had to beat the market by more than 2% every year.
"Those performance incentives, it should be emphasized, were frosting on a huge and tasty cake: Even if the funds lost money for their investors during the decade, their managers could grow very rich. That would occur because fixed fees averaging a staggering 21â„2% of assets or so were paid every year by the fund-of-funds’ investors, with part of these fees going to the managers at the five funds-of-funds and the balance going to the 200-plus managers of the underlying hedge funds."
The simple fact of the matter is these funds did not outperform. In fact, they substantially lagged the market over the period. According to the data displayed in the Berkshire Hathaway report, of these five funds, only one came close to beating the S&P 500 with an average annual gain of 6.5%. The other returns ranged from 0.3% to 3.6%. Over the same period, the S&P 500 index fund returned 8.5% per annum. I should point out, however, all of these funds beat the S&P 500 in 2008 by at least seven percentage points, so there is something to be said for the managers' skill in providing diversification.
Diversification is not good
What are the key takeaways from this? Well, for a start, the experiment shows that no matter how much fund managers are paid, or how intelligent they are, they struggle to outperform the S&P 500, which can achieve better returns at a fraction of the cost (via an index fund).
Second, it is interesting to note the diversification of these funds did nothing to help them outperform. If we assume each hedge fund owned at least 10 stocks (ignoring any overlap), Protégé would have had an interest in 10,000 equities around the world. Granted, fees will have impacted performance to some degree, but the fact only one of these funds-of-funds came close to achieving a return near that of the S&P 500, even when they are broadly diversified, shows just how much of a disadvantage diversification can be.
Disclosure: The author owns no stocks mentioned.
