You might be surprised to see occasional headlines bemoaning the poor performance of hedge funds compared to the market indexes. Not Warren Buffett.
Hedge fund managers serve two masters: their clients and themselves. That sounds like a solid alignment of interests, but it’s not, the billionaire investor says. That’s because hedge fund chiefs get paid win or lose.
The fixed annual fees hedge funds charge are the real money-makers, not the contractual “bonuses” for performance. By extension, Buffett is making a statement about active managers of all kinds. They’re not in the business of beating the market. They’re in the business of attracting assets and that’s all.
For example, a hedge fund managing $1 billion charges a fee of 2% of those assets per year plus 20% of trading profits.
Let’s assume the fund breaks even — no profits. That’s still $20 million in fees. When a hedge fund controls $20 billion, the income is $400 million.
Because of the fixed 2% fee, there’s less and less reason to worry about collecting the 20% of profits, Buffett notes. Rather, the funds reward themselves just for getting big. “[You] don’t have to particularly deliver. [The] promise lasts long enough to get you and your children rich,” Buffett explained.
It’s not surprising then that most hedge funds last about five years, and that one in three fails on an annual basis. Why not go into the hedge fund business? The worst that could happen is that you close up shop and move on, millions of dollars richer. The best outcome would be billions of dollars instead.
Millions, billions…after a certain point it doesn’t matter. There are only so many Hamptons getaways you can buy, only so many private college educations you have to finance. It’s the kind of wealth that endures for generations.
Take it down a big step, however, and you see exactly the same logic at ordinary mutual funds. At least hedge fund bosses have an excuse. Their investors are supposedly rich enough to know better.
That they don’t know any better and continue to throw money at “2 and 20” schemes is not a sign of sophistication or special access. It’s just dumb, and it costs those investors millions upon millions of dollars. That’s why CalPERs, the big California state pension fund, gave up on hedge funds in 2014.
Hedge funds and losses
But the same process Buffett warns about — short-timers trying to grift the system — is endemic across the retirement world, too.
Your 401(k) plan doesn’t hit you for 20% of profits. But it almost certainly collects close to a 2% annual fee (or worse) and that’s all that matters.
Your IRA plan fees seem okay at 1% a year. Do you realize that the underlying funds in your plan cost you another 1% or more? Your costs are well into hedge fund territory.
Nobody recognizes these costs until after the damage is done. It’s the main reason individual retirement portfolios are stuck in the mud year after year.
Lowering fees is the answer. Stocks and bonds do what they do. Prudent, low-cost management captures the lion’s share of those gains. High-cost, actively managed fund salesmanship, meanwhile, achieves the polar opposite.