In Berkshire Hathaway’s recently released shareholder letter, Warren Buffett took the opportunity to tear into hedge funds. Mr. Buffett had this to say about hedge fund managers: “If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.”
Buffett’s basic belief is that hedge fund managers are better at selling the promise of high returns than actually delivering it. And much of this inability to achieve high returns is due to the high fee structure that most hedge funds charge to their investors. In his criticism of hedge funds, Buffett does not specifically talk about the validity of shorting stocks, but for many funds, short selling has also been a major driver of underperformance vs. the S&P 500 index. For example, immediately following the financial crisis, long/short funds pitched themselves as market-neutral, that is their portfolios consist of equal portions of long investments as short investments. This was a great sales strategy in 2009. Investors walked away burned from the financial crisis and flocked to strategies that promised downside protection as part of their strategy.
However, shorting stocks in 2009 when the S&P 500 was trading at 10x earnings was the exact wrong strategy! Instead, funds should have been buying stocks (aggressively) and betting on stocks going up in the years to come instead of losing money short selling.
With that said, I do believe Buffett’s criticism of active managers does overlook the need for active management. If 100% of investor capital followed Buffet’s advice to invest in a passive S&P 500 index fund, then, who would be left to judge which companies should be rewarded with more capital or punished for poor management?
Companies should not be rewarded simply for being a member of the S&P 500, which is part of the problem in today’s market. So much capital is being attracted to low cost ETFs, which blindly pour money into the index (and thus each of the individual components) regardless of their merit.
At the end of the day, we still need professional investors to ask the tough questions to management teams and divert capital towards well-run, profitable companies. These professional investors may ultimately make less money as the hedge fund fee structure breaks down, but we still need active managers performing fundamental analysis on companies in order for financial markets to function properly. For now, the growing dominance of passive, ETF based investing may one day present its own risks to financial markets.
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