Buffett stings hedge funds anew over their ‘misbegotten’ rewards

SEATTLE: Warren Buffett’s sweeping endorsement of index investing is sure to sting the hedge-fund industry and encourage the stampede into assets that passively track the market.

In his well-read annual letter to Berkshire Hathaway Inc shareholders last Saturday, he estimated that investors wasted more than US$100bil on high-fee Wall Street money managers over the past 10 years.

He declared an early victory in his decade-long bet that a basket of hedge funds would fail to keep pace with an an S&P 500 Index fund. And he called Jack Bogle, the Vanguard Group founder who pioneered lowcost market trackers, a “hero.”

“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,” Buffett wrote. “Both large and small investors should stick with low-cost index funds.”

The message is already catching on. After years of underperformance, hedge funds are facing a revolt by endowments, pensions and other institutional investors that have decided they aren’t getting their money’s worth. Meanwhile, index funds have been on a tear. In 2016, passive strategies attracted US$504.8bil in new money, while active managers saw US$340.1bil in redemptions, according to data from Morningstar Inc.

“It offends his sensibilities since so many people have extracted so much from the system for so little net benefit,” said Steve Wallman, a money manager in Middleton, Wisconsin, who has invested in Berkshire since 1982. The letter is “going to have a massive ripple effect. It always does. And it should.”

Buffett’s annual report built on a critique he’s been making for years. In 2014, for instance, he wrote that he was planning to put most of the money he was leaving for his wife in a Vanguard S&P 500 tracker, saying it would outperform most people who hired high-fee managers.

Investors took his advice, and their enthusiasm hasn’t abated. In the 12 months ended Jan 31, the Vanguard 500 Index Fund had inflows of almost US$38bil.

The billionaire has made his point most visibly through a US$1mil bet with Protege Partners, which had said that hedge funds’ ability to short stocks would give them an advantage in falling markets. Buffett challenged the asset manager to pick a group of hedge funds that it thought would beat an S&P 500 Index fund over 10 years. Proceeds from their wager go to charity.

Last Saturday, he gave an update: A US$1mil investment in the bundle of hedge funds would have generated a US$220,000 gain in the nine years through 2016, compared with the index fund’s US$854,000 increase. That means it’s a near certainty Buffett will win when the bet ends on Dec 31. The billionaire estimated that about 60% of the gains that the hedge funds produced during that period were eaten up by management fees, which he called a “misbegotten reward.”

Beyond that critique, Buffett updated shareholders on progress at Berkshire, the now-sprawling conglomerate he’s run for more than five decades. Profit last year was little changed at US$24.1bil, as earnings from newly acquired manufacturer Precision Castparts helped offset a decline in income from the company’s railroad, BNSF.

He also pushed back against the assertion that share buybacks are “un-American” and offered a lesson in when they make sense. He criticised companies that adjusted earnings higher by omitting restructuring costs and stock-based compensation. And he again expressed his deep conviction that the US – a country that combined “human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law” – would thrive over the long haul and be a profitable place to do business.

Buffett also praised managers who run Berkshire’s businesses, name-checking several in the company’s insurance segment. But he made no detailed remarks on succession and was quiet on Wells Fargo & Co, one of his largest stock holdings. The bank is working to recover from a phony-account scandal. Nor did Buffett discuss the rationale for profitable new investments in Apple Inc and the four largest US airlines.

Many of his fans have found his embrace of index funds jarring, not least because he continues to pick stocks at Berkshire and hired two former hedge-fund managers in the past decade to help him oversee the company’s equity portfolio, which was valued at US$122bil at the end of 2016. – Buffett also helped usher in the boom in active investing by writing for years about how fads and fear in markets can make securities available at attractive prices. – Bloomberg