Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [27]
What does a good hedge fund make? It is supposed to make alpha, excess return—adjusted for risk—above and beyond a passive investment in the overall market, or beta. Alpha is supposed to be your reward for accepting extra risk. Hedge fund investors should expect nothing less from a hedge fund than from any other well-managed company. Just like actual hedge fund, I have no obligation to disclose my portfolio’s return, and I don’t. But my returns after all expenses and taxes are enviable by any hedge fund standard, and actual hedge funds have not given me much competition. Very few hedge funds achieve great returns, and if they do, they are not doing it consistently.
Part of the reason my personal returns are so healthy is that, unlike actual hedge funds, I do not withdraw fees ranging from 2 percent to 5 percent of the value of my portfolios each year, nor do I liquidate assets to pay myself 20 percent to 44 percent of the upside. My portfolios are tax efficient. I don’t charge myself administrative fees of around 0.5 percent per annum, and I don’t pay for research using “soft dollars” paid to investment banks by marking up trades at the expense of my investment portfolio. I don’t lend myself money from my investment portfolio. I don’t let brokers commingle my funds with theirs to potentially expose me to their credit risk, either. Unfortunately for their investors, traditional hedge funds usually do the opposite of what I do when it comes to fees and efficiency.
Finding the right hedge fund is like truffle hunting—and you need a good pig. Investors may find that fund of funds managers are no help in sniffing out truffles; they are often mere fee hogs. A large Chicago-based fund of funds manager recently observed that out of the universe of hedge funds, only about 25 met his standard for investment. He looks for a critical mass of employees, comprehensible strategies, and well-developed back-office operations. But he is having his own infrastructure problems since his staff cannot keep up with the new structured credit products that the hedge funds embraced. This lack of expertise comes at a high price: on top of hedge fund fees, many funds of funds charge a 2.5 percent load, more than 3 percent in annual expenses, and ask for 25 percent of the upside. Instead of compound interest, you get compound fees.
I reinvest my fees. If I would not take out fees for my own use, why would I pay them to a manager who has a mediocre track record? Yet many investors allow mediocre managers to suck the life blood out of their portfolios.
Do you want to know the fastest way to become rich in hedge funds? Run one.
Financial journalists deify hedge fund managers, who boast of elite sports abilities and savant-like mental powers. A money manager may show off his ability to play multiple chess games simultaneously instead of showing off verifiable weighted average returns.This is especially useful when managers do not have a long, reliable, credibly audited track record to boast about.
Blackjack card counting is offered as evidence of a hedge fund manager’s genius. I have played blackjack, I have counted cards, and I have won doing it. Unfortunately, playing blackjack will not make you a better money manager. The cards in the deck are known in advance. Even when casinos reduce the edge of a card counter by adding more decks, the cards are still known in advance. Real world finance is not as dependable. Not only does reality add more decks; it removes cards, and adds wild cards (fraudsters). Probability-based models fall apart. Besides, as Warren Buffett knows, the real action is in insurance companies, not casinos.
Warren Buffett plays bridge. What does this have to do with his ability to make lucrative investments? Nothing. It may help keep you sharp, but so would