Friday, May 12, 2017
Warren Buffett Responded
by Steve Haberstroh, Partner
Back in February, I wrote a piece in reaction to Warren Buffett’s discussion on hedge fund and investment management fees in his latest Annual Letter to Shareholders. The heart of my post was that yes, many hedge fund and investment managers are not worth the fees they charge, but much like how Buffett relies on his Co-Chairman Charlie Munger for financial advice, surely, the average investor can receive value when paying for financial advice and expertise. My final post ended, “So would Buffett be willing to pay his ‘advisor,’ Charlie Munger, 1% per year to help him manage large and impactful investment decisions? I’m willing to wager he’d say ‘yes.’”
You can review that post here: My Wager with Warren: A Reaction to Berkshire Hathaway’s 2016 Annual Letter to Shareholders
I wish someone took me up on that wager because at this year’s Berkshire Hathaway’s annual shareholders’ meeting, Warren spent over 8 minutes responding to that very question. And the author of that question happened to be yours truly. I was honored, and in attendance, when Carol Loomis, the long-time Editor of Fortune magazine, asked Warren the question I had submitted to her earlier this year:
Warren, you made it very clear in your annual letter that you think the hedge-fund compensation scheme of “2 and 20” generally does not work well for the funds’ investors. And in the past, you have questioned whether investors should pay “financial helpers” as much as they do. But “financial helpers” can create tremendous value for those they “help.” Take Charlie for instance. In nearly every annual letter, you describe how valuable Charlie Munger’s advice and counsel has been to you and, in turn, to the incredible rise in Berkshire’s value over time. Given that, would you be willing to pay the industry-standard “financial helper” fee of 1%-on-assets to Charlie or would you perhaps even consider “2 and 20” for him? What is your judgement on this matter?
Here is the link to footage from the event and the 8-minute response: Buffett: Hedge fund-style compensation in any other field would ‘blow your mind’
The truth is, after Mrs. Loomis indicated she liked my question and it had a good chance of being asked, my wife Erin and I headed to Omaha, cautiously optimistic that it would be chosen.
To describe the weekend as “life changing” might be hyperbolic, but it’s pretty darn close to the truth. I will never forget the feeling of having my name announced, and my question read to Warren Buffett and Munger. The fact that the Oracle of Omaha himself spent eight minutes articulating his answer was icing on the cake. Then to see financial publications such as YAHOO! Finance, the Wall Street Journal, Fox Business, Bloomberg and local blogs pick up the story?—it was exhilarating.
A thorough summary of the entire weekend and my takeaways that can be applied to our business, our clients, investing and life is for another post. For this discussion, I’d like to focus on my specific question and analyze Buffett’s response.
At the heart of his response was an admission that, of course, he’d be willing to pay Munger 1% per year and that he’d even pay Munger the hedge fund compensation arrangement of “2 and 20.” But he also stated that, “It’s not really a very good question” because that’s like asking (paraphrasing here) “should the Red Sox have paid to keep Babe Ruth?” In other words, Munger, as we know, has been invaluable to Buffett and his success in building tremendous value for Berkshire shareholders.
Here is a list of additional points he made in his response. Please forgive my paraphrasing:
- Hedge fund managers, “in aggregate,” are not worth the fees they charge. They are more like salesmen pitching “magical” investment products.
- The hedge fund industry is peculiar to Buffett as it “gets away with” charging high fees yet, “in aggregate, provides no value.” He compared this to plumbers and obstetricians. There is value added when hiring a plumber to fix a faucet or an obstetrician delivering a baby versus trying to do one or both yourself.
- The investment management industry (again, in aggregate) cannot outperform the S&P 500 Index after their fees (1% on average).
- However, Buffett admitted there are “probably thousands” that do outperform. He personally knows 12 or so who he believes have and will continue to outperform net of fees over time.
- He cautions that the average investor either cannot identify such managers on their own or would not be able to access those managers even if they could identify them (likely due to high minimum investment requirements).
- Most “average investors” are better off simply buying and holding inexpensive S&P 500 Index funds for life.
- Smaller funds have a better chance at outperforming than larger funds do.
- Berkshire pays its two in-house investment managers, Ted Weschler and Todd Combs, a $1 million salary plus a bonus if they outperform the S&P 500 Index.
First, I’d like to reiterate how honored I am to have experienced this interaction in person. Second, if I could change one thing about his response, I wished it started with a laugh and continued with Buffett and Munger busting each other’s chops about how much Munger is “worth.” Instead, the crowd laughed (you can hear it in the video) and Buffett took on a very serious, almost tenacious tone.
But, as Buffett has said in the past, “you should focus on things you can control.” I cannot control his response, but I can control my thoughts on what was said. And they are:
- I agree that most hedge funds and investment managers underperform the S&P 500 Index net of fees over time. Part of our job at CastleKeep is to try and identify those managers that have the talent, process and track record that do. We then endeavor to access them at the lowest cost possible. If we cannot identify such managers, low cost index funds and/or ETFs are useful options.
- At CastleKeep, we rarely use hedge funds. When we do, they are highly specialized and usually do not have the singular focus of outperforming the S&P 500 Index. One such hedge fund we use for certain clients focuses specifically on mortgage-backed-securities, which act very differently than the US stock market.
- I agree that, in general, as a hedge or mutual fund gets larger, it becomes more difficult for the manager to deliver outsized returns. The industry term for this phenomenon is called “asset bloat.” (Also, the 2% p.a. management fee as the fund grows may make managers more “comfortable” and less willing to take risks which may have been a large part of their previous outperformance.)
- Not all investors have the objective of “beating the S&P 500” over time. Consider someone saving for a home purchase in two years or a conservative, retired investor living off their life savings. Most qualified investment professionals would not recommend a 100% or even 90% allocation to the S&P 500 Index in those cases (as Buffett often prescribes). It would be irresponsible to do so in many situations.
- Even if an investor chooses to buy a low-cost S&P 500 index fund or ETF with plans to hold the security forever, history tells us it is virtually impossible for him/her to do so. Average investors typically sell securities after large sell-offs and tend to buy more securities when they are overvalued—the opposite of a sound investing strategy. We wrote about this in our 2016 Annual Letter to clients: 2016 Market Review.
So I got my wish and I won my wager (against no one). The reward was witnessing over 150 years of advice from two legendary investors, first-hand. There is no doubt that Buffett and Munger are a dynamic duo. The chemistry between them is palpable and was evident for eight straight hours on stage. I suppose I shouldn’t have been surprised since they have successfully co-existed, leading what is now a Fortune 5 company (yes, 5 not 500).
When the presentation started, Buffett and Munger took their seats at center stage. Buffett addressed the crowd, “That’s Charlie, and I’m Warren. You can tell us apart because he can hear and I can see. We work so well together because we each have a specialty.”
While the effect of this introduction was to engage and lighten up the crowd, after spending eight hours with Buffett and Munger, I have realized a deeper meaning. Buffett has the big ideas. He can “see” what most of us can’t when evaluating a business or investment. But recognizing an opportunity (or danger ahead) is half of the equation. Munger can “hear” Buffett articulate his ideas. He has “heard” them for more than 50 years. Armed with this ability to “hear,” and enhanced by their experience and chemistry together, Munger can help Buffett both capitalize on opportunities and recognize potential “mistakes.”
In this year’s annual letter to shareholders, Buffett wrote, “I will commit more errors; you can count on that. Fortunately, Charlie—never bashful—is around to say ‘no’ to my worst ideas.”
So what is it worth to have a trusted advisor who listens to your ideas, helps articulate your objectives, advises against potential pitfalls in a constructive way, and helps execute and evaluate progress in this ever-changing world?
I’d say an awful lot. And Warren Buffett agrees.