Warren Buffett (Trades, Portfolio) is possibly the financial world's most vocal critic of hedge funds.
He has long claimed that hedge funds do not justify the fees they charge and put his money where his mouth is in 2008, making a bet with Ted Seides, a former asset manager at Protégé Partners, that a basket of hedge funds would not outperform the S&P 500 over the next decade.
Buffett's bet
Buffett won this $1 million bet easily. Over the course of the bet, the S&P 500 index fund returned 7.1% compounded annually, compared to a return of just 2.2% per annum for the basket of hedge funds selected by Protégé.
The proceeds of the bet were donated to charity, and Buffett used his investment prowess to increase the sum returned to Girls Inc. -- his charity of choice.
Buffett and Protégé initially put around $320,000 into bonds for the bet that was expected to appreciate to $1 million over the course of the 10 years. As it turns out, the bonds appreciated faster than expected and in 2012, the bettors decide to sell up and invest the proceeds in Berkshire B-shares. When the result of the bet became clear, Girls Inc. received a total of $2.2 million.
Buffett is critical of hedge funds today, but when he first started managing assets for outside investors in the early 1960s, he used a strategy that's very similar to that same one used by long-short equity hedge funds today.
Buffett and pairs trading
Called pairs trading, the strategy involves going long one stock and short another in the same industry or sector. It is effectively a bet on one company doing well while the other struggles.
As it turns out, Buffett actually learned this technique from the godfather of value investing, Benjamin Graham, as he described at the Berkshire Hathaway annual shareholder meeting in 2008:
"[It] would be called pair trading now, which is a technique that’s used by a number of hedge funds, and perhaps others, that go long one security and short another, and often they try to keep them in the same industry or something...that technique was employed first by Ben Graham in the mid-1920s when he had a hedge fund, oftentimes —I read articles all the time that credit A.W. Jones with originating the hedge fund concept in the late ’40s, but Ben Graham had one in the mid-1920s —and he actually engaged in pairs trading."
The Oracle of Omaha went on to say that borrowing stocks back then was significantly harder than it is today; he actually had to go to shareholders and ask to borrow their share certificates:
"We did —we shorted out the general market for about five years in the partnership, to a degree. We borrowed stocks directly from some major universities. I think we were probably quite early in that.
We went to Columbia and Harvard and Chicago and different places and actually arranged for direct borrowing. They weren’t —it wasn’t as easy to facilitate in those days as it is now.
And so we would take their portfolios and we would just say, “Give us any of the stocks you want, and then we’ll return them to you after a while and we’ll pay you a little fee."
Most of the time, Buffett wasn't looking to short specific securities. He was just looking to sell the whole market as a hedge against his long portfolio:
"And then we went long things that we thought were attractive. We did not go short things that we thought were unattractive;we just shorted out the market generally."
He then said that the strategy was relatively limited by the number of institutions that were happy to lend these securities to Buffett and his associates and while being able to short securities did provide some additional profits for his early partnerships, it was "not a big deal."
Even though it wasn't a particularly big deal, I think it is still a fascinating insight into the way Warren Buffett (Trades, Portfolio) made his first millions and the opportunities he was able to take advantage of at the time to gain an extra edge over the rest of the market.
Disclosure: The author owns shares in Berkshire Hathaway.
