It’s been 10 years, and mercifully this media fracas is over.  Warren Buffet’s bet with Ted Seides (while at Protégé Partners) is officially done, per the 2017 Berkshire Hathaway annual letter.  The bet has become the rallying cry behind the migration towards passive management, the push back towards management fees, the tidal wave against hedge funds, and perhaps an assault on endowment-style portfolios.

Of course, Buffett and Co. have been antagonists towards endowment style portfolios for some time.  Just read Charlie Munger’s 1998 speech to the Foundation of Financial Officers.  In it, he attacks the benefit of complexity when accompanied by layered management/consulting/administrative fees.  He questions how multifaceted portfolios with diversified assets can lead to superior outcomes versus highly concentrated holdings in a handful of superior operating businesses.

While The Bet is not quite the same (i.e., concentrated basket of stocks vs endowment-style portfolio), Buffett’s condemnation of the “fund-of-hedge-funds” model is scathing.  He highlights how hedge funds and fund-of-hedge-funds have every correct incentive to outperform, but are ultimately undone by the sheer expense that is passed through to the end client.  As he wrote in his most recent annual letter:

“Those performance incentives, it should be emphasized, were frosting on a huge and tasty cake: Even if the funds lost money for their investors during the decade, their managers could grow very rich. That would occur because fixed fees averaging a staggering 21⁄2% of assets or so were paid every year by the fund-of-funds’ investors, with part of these fees going to the managers at the five funds-of-funds and the balance going to the 200-plus managers of the underlying hedge funds”

While fees are a significant component of why these investments lagged the S&P 500 for the preceding decade, they are not the entire portion of the equation.  A large part was the cost of tail-risk protection that fund managers paid for, whose expenses were never compensated.  In the ensuing years after 2008, true tail-risk scenarios never materialized, at least in the ways that active managers protected against.

There were several potentially cataclysmic events that occurred between 2009 and 2017.  To highlight a few: an existential crisis for the European Union that risked the dissolution of the currency union (with multiple ensuing flare-ups, and a Brexit), an acute solvency crisis of the US government (2011), a 2015 market environment that was akin to a recessionary environment (save for a stable of tech giants), and several geopolitical events that ravaged pockets of the market (e.g., Shale/OPEC in 2014).

Active managers are paid to evaluate risk, and in each of these situations, the cost of risk was not accurately priced into the S&P 500.  By that, I mean reducing exposure or hedging through tail-risk protection was the prudent course of action, given the non-zero probability of significant impairment.  We rationalize after the fact that the hedges and “risk on / off” scenarios were poorly traded, given of how the market bounced back.  But what if it didn’t?  What if we had a redux of the 1930s with follow-on recessions and continuously slumping markets?  We lionize central bank monetary policy after the fact, but it was never clear that the landing would be stuck.   In some circles, it still isn’t.

One final point: managers who did not “de-risk” their exposures in 2008 saw rashes of redemptions before their risk appetite could be repaid in 2009.  In effect, these managers who exhibited the type of behavior that a permanent capital investor would have liked to see where often punished dearly.  The psychological impact can’t be overlooked in the ensuing years.

This is not a mea culpa for active management.  There were many unforced errors leading to underperformance.  But it is a condemnation of breathless coverage of outcomes rather than a decomposition of probabilistic thinking.  It is also a stark realization that quality of LP matters almost as much as quality of investment idea.

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Faryan Amir-Ghassemi

Author Faryan Amir-Ghassemi

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