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Warren Buffett and the Quest to Expose the Hedge Fund Scam

Warren Buffett: Do as I Say

Written by Geoffrey Pike
Posted May 18, 2016

 bufundBack in 2008, Warren Buffett made a one million dollar bet with a money management company called Protégé Partners. Buffett’s bet was that his pick of an S&P 500 index fund would outperform Protégé’s pick of five “funds of funds”.

It is a 10-year bet, so they are only 8 years into it. Buffett recently bragged about his overwhelming lead at his annual meeting. Despite the crash in stocks that followed soon after the bet went into effect, Buffett’s pick is now up about 65%, while the funds picked by Protégé are up just over 20%.

As pointed out in a recent piece in Fortune, this bet favored Buffett all along because of the big trading fees associated with hedge funds.

In this particular case, the investment was five funds of funds. A fund of funds is a strategy of holding multiple investment funds as part of a portfolio, instead of investing directly in the stocks or other investments.

Therefore, investors are really taking a double hit with fees. A typical hedge fund will charge fees of 2%, plus oftentimes taking a percentage of the profits. With these funds of funds, you get a second level of management fees for the managers choosing which funds to include.

When you are already at least 3% in the hole, it is rather difficult to beat a basket of stocks like the S&P 500, especially when you will have some overlap of the investments anyway. Meanwhile, an index fund investing in the S&P 500 will charge minimal management fees that are just a small fraction of a percent.

So with two years to go in the bet, it looks like Buffett will come out on top. The million dollars of his winnings will go to charity. It would be a drop in the bucket to Buffett.

But the real lesson here isn’t to take financial advice from Warren Buffett. The lesson is to stay away from hedge funds unless you really know what you are doing. Even if the managers are really good – which they often aren’t – the profits will get eaten up by fees.

Do As He Does

Warren Buffett has obviously been an incredibly successful investor. Sometimes he offers really good advice, while other times I can’t figure him out.

Buffett’s father, Howard Buffett, was a congressman back in the early 1950s. He was a strong proponent of the free market and an advocate of gold-based money. Warren fell far from the tree.

Warren Buffett calls for higher taxes on the rich, even though he won’t voluntarily hand over more of his money to the government. He is an Obama guy. He is a crony capitalist to a large degree, which isn’t really a capitalist at all. He does not believe in free markets. He only believes in them up to the point of his own benefit.

Still, with his success, you can learn things from him. He is known for finding really solid companies to invest in for the long term.

The problem is, this isn’t what he advocates. He says that people should just buy an index fund of the S&P 500 and hold it for a long time.

If someone had invested in the Japanese stock market in 1989, they would still be down by about half nearly 3 decades later. Buffett would probably respond that U.S. stocks are stronger. But most people thought Japan was pretty strong in the 1980s.

I am a big fan of diversification for protecting wealth. I don’t think investing in a stock index fund is proper diversification. It does not protect against a recessionary/ depressionary environment. It does not do enough to protect against high inflation.

In addition, although a strategy of diversification should be used to protect wealth, it isn’t going to make you rich like Buffett, or anywhere close to him. If you want to be successful, you actually have to not diversify, at least at the start, with some of your money. This could mean investing in individual companies, starting your own business, learning a new skill, or any number of things.

If you are 30 years old with $20,000 to invest, you aren’t going to go very far sticking it all in a stock index fund and letting it ride. It isn’t to say you should take big risks with it either, but you should be aware that you will need to generate more income in order to obtain a significant level of wealth.

I don’t know if Warren Buffett actually thinks investing all of your money in a stock index fund is a good idea, or if he just says it in an attempt to prop up the market. Either way, it isn’t good advice. It isn’t the worst advice in the world, but we should expect better from the man who is known as the world’s best investor.

You don’t have to invest in hedge funds that charge high fees, and most of which can’t beat stock index funds. But you also don’t have to buy stock index funds. There are other roads to take with your money.

Buffett says, “Do as I say, not as I do.” I say, “Do as Buffett does, not what he says.”

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