Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [30]
Warren does his best to create transparency. His shareholder letters try to explain everything, even anomalies created by accounting and conventional reporting. He even explains his derivatives positions and educates investors on potential volatility of earnings. His investors can find him at the annual meeting, and he and Charlie Munger entertain detailed questions for hours on end.
The offshore location of many hedge funds makes it easier to keep investors from second guessing managers. Moreover, managers do not even have to tell you when they change strategies, as long as the documents you signed allow them to do it.There is usually a waiting period for withdrawing your investment from a fund, so in the meantime, you just have to take a manager’s word for how well they are doing.
A hedge fund manager usually has an anecdote, an after-the-fact anecdote, about how he made a small fortune on a prescient bet on, say, the renminbi. He will leave out the part about the large euro trade in which he lost a large fortune. The manager is rarely able to tell you about his current trades; he will claim he doesn’t want other managers to know his strategy.
Hedge funds do not create new asset classes or new investments, and investing in them does not necessarily make you more diversified. You cannot be more diversified than the market portfolio, and hedge funds trade in the global markets. If you go long and short market assets, as traditional hedge funds used to do, the mix does not become more diversified. The stock market offers a simple way to look at this. Together, passive and active investors own 100 percent of the global stock market. The average return of all passive and active investors together is exactly equal to the average return of the global market. The average return of passive investors, the indexers, is also equal to the average return of the global stock market.
This means that active investing is a zero-sum game. Given that passive investors’ return is the average, active investors must also have the same average return as the global market, before fees, before expenses, and before taxes. If some hedge funds wildly outperform the market, as some claim to do, other hedge funds must spectacularly underperform. Fees, expenses, and taxes just make the spectacular underperformance even worse. Tavakoli’s Law states that if some hedge funds soar, some must crash and burn.
Hedge funds protest that active investors also include some small individual active investors, and they say they are making money off of those people. But there is no evidence that is true. I do not buy the argument that, on average, individual active investors underperform hedge funds. It is probable that individual active investors outperform hedge funds after one adjusts for creation bias, survivorship bias, fraud, other misleading methods of reporting returns, and high fees.
Taken as a whole, active managers in the market will underperform the market average by an amount equal to their cost of trading (their trading commissions plus their total fees). This is true for hedge funds, mutual funds, and an individual investors’ stock portfolio. Unless you can consistently improve your assets by trading, the less one trades and the lower one’s fees and commissions, the better off an active investor will be.
Investors are only human, and human beings are not good at assessing probabilities (and therefore risk) without formal training. Even experts sometimes have trouble. Scientific American’s Martin Gardner authored a section on mathematical games and asserted that in probability theory it is “easy for experts to blunder.”17
One study suggests that people with injuries to the frontal lobe might be better investors, even though this type of brain damage results in