Betting on (and with) Buffett

Had you bet on Buffett back in 1965, you would’ve made 11% more than the S&P 500, compounded annually and including all dividends from those companies that issued one. Of course, back then no one knew that Warren Buffett was going to go on to build one of the most successful companies in the world, so placing a bet on him would’ve been akin to finding a needle in a haystack, except finding The Oracle would’ve paid vast sums more than finding the needle.

Berkshire Hathaway, the company Buffett built from essentially the ground up, had a gain in net worth in 2017 of $65 billion. That’s a staggering figure for merely one year of performance. Buffett himself admits that only $36 billion came from operations, with the remainder being delivered via a change in the tax code, but nevertheless it’s still a formidable statistic. Investors yearn for the next great investment manager who can deliver outsized returns on a consistent basis like Warren has done for decades; many even attempt to match the returns he has realized over the years by actively buying, selling, trading, and managing investments on behalf of others. But the failure rate is so high, that the average investor is almost better off sticking with Buffett’s sage advice and buying a simple index fund and holding it long term.

The bet

We’ve discussed the decade-long bet before in our writings, but the final results are in and the million-dollar prize money has been awarded to Buffett, who took the side of the passively managed S&P 500 index fund. Protégé Partners was attempting to debunk Buffett’s conviction – and the market in general – that it could pick funds (and fund managers in particular) that could outperform a low-cost index fund. What’s more, they could pick any fund at any time during the ten years, while Buffett was limited to just one fund for the duration of the bet.

Protégé chose 5 “fund of funds”, which in turn owned interests in 200+ hedge funds. In essence, Protégé could pick “the best of the best” money managers in the world at the time (from 2007 to 2017) and they must have been oozing with confidence after the first year, when they lost less money in each of the funds (the worst performing fund losing 30%, the best fund losing 16.5%) than the S&P 500 that year, which lost a whopping 37%. Obviously, Buffett knew there would probably be a reversion to the mean shortly after the first year of losses, and that’s exactly what happened.

The chart below shows just how outmatched stock pickers were to a “do nothing” strategy that your average superstar money manager would most likely scoff at lest their life’s work be exposed as meaningless.1

The lessons

Final gains for the actively managed fund ranged from a mere 2.8% to a respectable 88%. The S&P 500 returned 125.8% over the period. Doing less with your investments would’ve been more rewarding than trying to time the market, buy low and sell high, or pay someone exorbitant fees to manage your money for you. The fees were the straw that most likely broke the camel’s back on this bet. Buffett reported in his annual letter – a wealth of knowledge in and of itself – that the fund of funds averaged 250 basis points (2.5%), making it a lucrative endeavor for the manager, often at the very literal expense of the investor. In contrast, the index fund’s fee usually ranges from 10 to 20 basis points, and sometimes even lower.

Performance is always impacted by fees because the investor is guaranteed to lose by the amount he or she pays in fees, but there’s never a guarantee that anyone is going to match or beat the market as a whole. We’ll end with a very telling statement from Warren in that very same annual letter: “Performance comes, performance goes. Fees never falter.” Simple is best, bet with Buffett when it comes to your hard-earned savings.

1. http://www.berkshirehathaway.com/letters/2017ltr.pdf

Hedge Fund Folly

2017 was not the best for hedge funds. The average hedge fund returned 8.5% for the year, which isn’t all that bad if the risk-adjusted returns aren’t taken into consideration.1 But when you compare it against the S&P 500 return of 21.8%, it’s an embarrassment to an industry that markets its services based on the skill of its managers. A folly of sorts since skillful fund managers are few and far between. The investing public at large is disqualified from investing in hedge funds, and that’s probably a blessing in disguise. It’s the institutions and the high net worth individuals that are uniquely qualified to take their chances, roll the dice, and pray that their millionaire managers can outperform a simple index fund.

This is not to say that hedge funds can’t outperform, indeed many hedge funds return in excess of the S&P 500, or any other benchmark that they’re measured against. Whale Rock Capital and Light Street Capital, two relatively smaller hedge funds, returned 36.2% and 38.6, respectively in 2017. But the hard part is selecting which fund will outperform on an annual basis because this year’s winner tends to become next year’s loser.

Pershing’s peril

Bill Ackman’s Pershing Square Capital Management returned an outstanding 40.4% in 2014, and money poured into his fund resulting in a massive increase in assets under management (AUM). He literally became the golden boy of the hedge fund industry over night, despite the fact that his previous fund imploded in a somewhat disastrous fashion. Bill Ackman is a marketing genius, though. His public assault on Herbalife made headlines for months, his appearances on CNBC were nothing short of entertaining, and his marathon presentations on his activist positions only added to his popularity. The year after his great run which beat the S&P by 26.7%, he saw a 60% slide to the negative, and investors went elsewhere with their money. Each year since then has only driven investors away and Ackman’s AUM has fallen by the billions.

Is Bill Ackman a talented investor? Yes, to a certain extent he is. He has taken great positions in companies and actively sought to turn those companies around. Is Bill Ackman a master marketer? Absolutely. Had you invested with Ackman through thick and thin since 2013, you would’ve made an abysmal 17.1%, before his outrageous fees. Net of fees, you would’ve lost to inflation with just a 1.4% gain from January 2013 to November 2017. The S&P returned 100.1% during that time, and the fees for investing in that fund did not make the manager a millionaire, let alone a billionaire like in Ackman's case.

The fee paradox

So if hedge funds aren’t producing superior returns why do they still attract money? In our opinion, it comes down to exclusivity. Wealthy investors want to separate themselves from the masses, even if it means putting more money at risk without any long-term assurance of decent returns. It’s almost a mathematical certainty that hedge managers won’t be able to beat an index fund after accounting for their 2 and 20 fee structure. The industry has traditionally taken 2% of AUM and an additional 20% of profits which makes it that much more difficult to continually beat the market. A basic index fund available to your Average Joe can be had for just 4 or 5 basis points, which is nearly 97% cheaper than the average hedge fund. Still, money continues to flow into the hedge fund industry with just over $3 trillion in AUM as of this writing.

We’ll end with a very revealing chart of hedge fund investing: The relative performance of the average HF vs. the S&P over the past 12 years ending in 2017.2 Only 2 of those 12 years have outpaced the S&P, so the next time someone brags about being invested in “alternative” funds, the chances are they’re losing to the guy next door who invested in the most basic of funds.

1 https://www.investopedia.com/news/2017-hedge-funds-return-less-half-sp-500/

2 https://www.theatlas.com/charts/ByYxH-w8f

Are REITs right for you?

A real estate investment trust, or REIT, is a type of investment that allows people to pool their money to invest in a collection of real estate assets. So, instead of going out and purchasing a property, fixing it up, and renting it out to tenants, you would simply invest in a REIT to take advantage of both the cash flows and capital appreciation it might offer, without all the hassle of going it alone. The fiduciaries of a REIT have incentive to pay out at least 90% of all the income the REIT generates to not be taxed as a corporation. That income flows through to the investor in the form of a dividend. You sit back, relax, and collect that income.

There are two types of REITs that are entirely different, so it’s important for investors to know which one (if any) is right for them. Equity REITs are the more traditional and stable REIT that most investors would be familiar with. The owners of this type of REIT would buy and usually operate everything from single-family homes to large shopping malls and industrial buildings. The lease payments from the tenants would count as the income that would be paid out to investors and the REIT would make money by retaining the 10% that is not paid out, along with any capital appreciation that would hopefully occur with the portfolio of properties. In contrast, mortgage REITs would tend to borrow at lower, short-term rates and buy at higher, long-term rates. Any spread from the two would become profit for the REIT. The risk involved with mortgage REITs is usually higher than equity REITs because more speculation on interest rates is associated with the former, whereas the latter is more focused on the income the underlying asset produces. Equity REITs would be more similar to a bond and mortgage REITs would be more similar to investing in options, where more leverage is used and more speculation is employed.

How REITs stack up, performance-wise

The best way to measure the performance of a REIT is to take a look at a particular index that would track it. For purposes of this article, we’ll discuss equity REITs. Keep in mind that the annual dispersion of returns for these indexes has ranged from 0.53% to 4.23% over the past twenty years.1 The five indexes that we’ll examine are the Dow Jones, FTSE, MSCI, S&P, and Wilshire. For 2017, if you took the average of these five indexes, your equity REIT would have returned 5.7%. In comparison, the S&P 500 index returned 21.14%, with dividend reinvestment. Of course, not all years will end up like 2017. If we look at the average return of an equity REIT from 2002 to 2016, U.S. REITs returned 12.84%, the highest average among the other asset classes listed in the figure below.2 Global REITs weren’t far behind, returning on average 12.62% over the period. In comparison, large cap stocks returned about 8%.

Figure 1: Total returns by asset class, 2002-2016

Source: Morningstar

REITs, just like any other asset class, have had their bad years. In 2008, the average REIT lost 38% in value; however, had you stuck with the investment for the two years after the Great Recession, you would’ve seen a bounce back of about 28% for both years, essentially erasing the losses in 2008. As avid long-term investors, we’d advise against jumping in and out of REITs as the year-to-year fluctuations can be substantial. A good historical benchmark is to look at REITs over a 10-20 year period, and if you do that, on average, a well-performing REIT should return in the high single digits.

Perhaps one of the most important reasons that REITs manage to attract large amounts of capital is because of the low correlation to the stock market. For example, when the stock market lost 9% in 2000, real estate investment trusts were up 34%, on average. This inverse correlation has changed slightly with the introduction of REITs to the S&P 500 in 2001, but the correlation is still below 1, meaning the two are still not moving in unison. The addition to the S&P, though, did create an environment where stocks and REITs move more in tune with one another. In 2004 the average correlation between the two was 0.44; a decade later it was 0.79.3

Keep diversifying

Investing should never be an all or nothing mindset. Diversification should be the hallmark of an investment strategy aimed at creating real wealth over time. Having an equity or mortgage REIT in your portfolio will likely protect against the occasional dips the stock and bond markets might experience over time. It will also add an element of income streams to your portfolio in the form of regular dividends that these REITs pay out to retain and attract new investors. Real estate is a good asset class to invest in, and REITs make it possible to enjoy all the benefits without getting your hands dirty yourself.

1. https://www.bogleheads.org/wiki/US_equity_REIT_index_returns

2. https://www.principalglobal.com/documentdownload/77610

3. Correlation Building Between REITs and Other Stocks. Morningstar. October 8, 2015​