This implies that a hedge-fund manager can build up a brilliant track record—but with no guarantee that he can keep it up. And that may explain why so many hedge-fund managers get rich, and why their clients are much less likely to do so."
Warren Buffet's Bet
Warren Buffet, the "Oracle of Omaha", has long been held up as an icon for stock-pickers and active investment managers. However, Buffet, who has famously trounced benchmarks such as the S&P 500 over several decades, argues that the average investor would be wiser to invest in low-cost index funds rather than in active funds. His line of reasoning is essentially the same as provided by Sharpe.
Buffet sees fees as the main difference between the expected performance of active and passive portfolios. So he has long advocated the idea that, on a net of fees basis, investors in active funds are likely to receive a lower return than investors in passive funds.
Based on this thinking, Buffet has now made a bet with a hedge fund manager about whether hedge funds can outperform an index fund over ten years. The period of the bet started on 1st January 2008. Progress will be reported each year, at the Berkshire Hathaway annual meeting.
Going into specifics, Buffet has selected the "Admiral" shares in the Vanguard S&P 500 index fund. These incur an annual fee of 7 basis points. The hedge fund managers (Protégé Partners LLC) have selected five "funds of hedge funds" as their representative in the bet. According to the report by Carol J. Loomis (who edits Warren Buffet's annual shareholder's letter at Berkshire Hathaway), Protégé will have to contend with a very high level of fees when calculating their performance in this bet. Each Fund of Funds charges a 1% base fee, while the funds themselves charge a 1.5% base fee. This makes a total base fee of 250 basis points.
Then come the performance fees for the hedge funds. These are 20%. According to the report, these 20% performance fees seem to be charged on the total gross performance of the hedge funds, i.e. the benchmark is effectively zero. Then the funds of funds take at least 5% of what is left, before the investor receives the return. The total performance fee level is thus 24% (or more). These performance fees are of course additional to the base fees.
It is easy to see why Buffet ridicules this sort of fee structure. Just as hedge funds represent the ultimate in active management, their fee structures represent the ultimate in fee structures. Buffet derisively refers to all the beneficiaries of these fees as "helpers" for the investor. His argument has long been that, because these numerous "helpers" all take a generous cut in fees, a hedge fund investor will be very lucky to consistently obtain net returns that are higher than those produced by a low-cost index fund.
For the hedge fund to win this sort of bet, it will most likely need to consistently perform very well. What are the chances of that?
Finding a Consistently Good Hedge Fund Manager
Hedge funds tend to be very secretive. This is especially true in the USA, where onerous laws prohibiting the widespread marketing of hedge funds mean that they usually try to even keep their names (let alone their performance records) hidden from the public. So it is not very easy to find good evidence about consistently successful hedge fund managers.
In itself, this opaque tendency of the hedge fund industry is a good reason for caution. It is seldom wise to invest in any portfolio that is not open to public scrutiny.
However, taking into account the existing legislative environment, it is worthwhile to consider what a consistently high-performing hedge fund would look like if one could find it. Suppose that a particular investment manager has developed a market-neutral investment process that typically produces returns that have zero correlation with equity markets, and performance that produces an information ratio of 2.0 against a cash benchmark, with tracking error of 6%. Some hedge funds do have this kind of performance record over periods as long as a decade, although it is very hard to find them.
A hedge fund that could consistently perform in this way is a very impressive money-making machine. There would be an enormous demand to invest in this fund. Most likely (and this is the case with some high-performing hedge funds that we have seen), the investment manager would need to limit Assets Under Management (AUM) because any high-alpha investment strategy will inevitably have capacity limitations. In such a case, isn't it fair for the investment manager to charge a very high fee?
Indeed, some hedge funds operate at full capacity, and turn away droves of investors who would be willing to pay even more than the 2+20 fee in order to access the returns offered by the fund. In cases like this, the investment manager could justifiably argue that the fee levels are remarkably restrained. After all, if the manager had no scruples about charging higher fees, they probably could do so in cases such as this.
Of course, all good things come to an end. Any fund that reliably outperforms carries within itself the seeds of its own destruction. High returns imply rapid growth in Assets Under Management, even if inflows are choked back to zero. As the portfolio size grows larger, the portfolio will start arbitraging away the market inefficiencies that have permitted it to outperform. It therefore seems almost inevitable that, even if a portfolio can reliably outperform for one or two decades, it will still revert to the mean eventually.
This may be a decisive factor motivating Warren Buffet's 10 year bet. It may be true that Protégé will be able to find some hedge funds with consistent records of outperformance. And it may even be true that this performance will tends to persist for some years. But it will be very hard for a group of hedge funds to consistently maintain outperformance over a ten year period.
It is worth noting that none of these ideas are inconsistent with Sharpe's propositions about the arithmetic of active management. Sharpe demonstrated that the average active manager will provide gross-of-fees performance that is in line with the average passive manager, and net-of-fees performance that is somewhat lower than the average passive manager. It is still possible for some of the active managers to outperform passive managers some of the time.
Grinold and Kahn
A credible claim for the existence of consistently skilled active managers is made by Richard C. Grinold and Ron Kahn. Their text, Active Portfolio Management (see box on left) is the main reference source for a new breed of scientific active investment managers.
"The first necessary ingredient for success in active management is a recognition of the challenge. On this issue, financial economists and quantitative researchers fall into three categories: those who think successful active management is impossible, those who think it is easy, and those who think it is difficult. The first group, however brilliant, is not up to the task. You cannot reach your destination if you don't believe it exists. The second group, those who don't know what they don't know, is actually dangerous. The third group has some perspective and humility. We aspire to belong to that third group, so we will work from that perspective. We will assume that the burden of proof rests on us to demonstrate why a particular strategy will succeed."
A CNN article "The Best Investors You've Never Heard Of" gives interesting background on the work of Grinold and Kahn.
Series Accounting, Equalization, and Other Fee Calculation Methods
These are methods for calculating performance fees. They try to find a solution to the problem of treating all investors equitably.