Warren agreed that I should share the memo with others, and I sent it to several people, including Richard Beales, at the time a reporter at the Financial Times, who was looking for news. The paper posted the entire letter on its Web site.
Jamie Dimon, CEO of JPMorgan Chase, wrote me that he agreed with Warren. When people justify their actions with the excuse that everyone else is doing the same thing, it is a red flag.
Warren walks his talk. When he took his stance in the 1980s that stock options should be expensed, it was an unpopular viewpoint. The SEC and U.S. politicians pressured to continue the practice. On Christmas Day 1994, the New York Times’ Floyd Norris handed out a “Consumer Deception Award” to Arthur Levitt, then chairman of the Securities and Exchange Commission. Levitt praised the Financial Accounting Standards Board for “great courage” when—after succumbing to political pressure—FASB backed down from requiring that executive stock options be expensed.17 Even though the FASB, politicians, corporate executives and the SEC supported the opposite view,Warren Buffett never wavered.
Neither Warren Buffett nor Charlie Munger takes stock options, restricted stock, or huge cash payouts as part of their compensation packages. Berkshire Hathaway is run more like a partnership than a typical U.S. corporation. The annual report includes “An Owner’s Manual” outlining the partnership commitment. Warren Buffett’s and Charlie Munger’s net worth is due to their Berkshire Hathaway stock holdings, and the other board directors are heavy investors in the company, too. Their own gains and losses are in direct proportion to that of other shareholders.
Buffett and Munger draw a salary of only around $100,000. Their wealth grows as they create value for others. Successful value investing is not a get-rich-quick scheme, it is a way to get rich and stay rich.
Benjamin Graham wrote that a speculator “wants to make his profit in a hurry.”18 The global capital markets suffered because people with access to other people’s money wanted to get rich in a hurry, and “investing” seemed to be the last thing on their minds. Backdating executives put their own compensation ahead of investors’ interests. But stock option backdaters are not alone in seeking extraordinarily compensation. Investment bankers that ended up subtracting value from the global capital markets earned millions of dollars for a single year of bad work. Many hedge fund managers create much less value than the prairie princes (Buffett and Munger), yet they rack up compensation in the hundreds of millions of dollars.
Chapter 4
The Insatiable Curiosity to Know Nothing Worth Knowing (Oscar Wilde Was Right)
I particularly liked the “Dean Man’s Curve” commentary [ Jan and
Dean wrote the song, “Dead Man’s Curve,” and I took Warren’s
message to be an intentional reference.]
—Warren Buffett
to Janet Tavakoli, September 27, 2006
Warren Buffett has nothing against hedge funds, provided the price is right for the risk. After our lunch in Omaha,Warren showed me the letter he sent when he made his rejected bid for Long-Term Capital Management (LTCM). Along with Goldman Sachs and AIG, Berkshire Hathaway made a $250 million bailout bid for LTCM and would have provided an additional $3.63 billion of funding.1 Instead, the Fed engineered a bailout with a consortium of 14 banks and investment banks; only Bear Stearns famously refused to participate. LTCM had once shorted shares of Berkshire Hathaway—a money-losing bet.2 That is what happens when eggheads crack.
My former Merrill Lynch boss, the late Edson Mitchell, was the banker who oversaw Long-Term Capital Management’s initial fundraising. 3 One of my Salomon training classmates, Swiss-born Hans Hufschmid, a partner and co-head of LTCM’s London office, had borrowed $14.6 million to increase his stake in the fund.4 In 1993, Salomon denied rumors that Hans’s compensation was as high as $28 million. Perhaps it was only $20 million. Hufschmid decamped for LTCM, because he thought it was a better opportunity.5 John Meriwether was a managing partner (formerly head of Salomon Brother’s arbitrage group) and a University of Chicago MBA. LTCM’s staff included Myron Scholes and Robert Merton, co-winners of the 1998 Nobel Prize in Economics, pioneers of equity option model pricing. David Mullins, a former Federal Reserve Bank vice-chairman, was also a partner. LTCM opened for business at the end of February 1994. In the late 1990s, LTCM was the largest hedge fund in the world, until it lost around $2 billion on its highly leveraged investments.
According to When Genius Failed, Roger Lowenstein’s book on the Long-Term Capital Management failure, if you invested $1 at the end of February 1994 when LTCM opened for business, it would have been worth $4.11 in April 1998 and only 33¢ by the time of the September 1998 bailout. But that was before fees. After fees that dollar would have been worth only $2.85 at its heyday value at the end of April 1998 and it would have been worth only 23¢ at the time of the bailout.6
Meanwhile, a dollar invested in Berkshire Hathaway at the end of February 1994 would have been worth $4.44 in April 1998, and while much of the market suffered, it still would have been worth $3.95 at the time of the LTCM bailout. Berkshire Hathaway handily beat LTCM’s peak performance, as shown in Table 4.1.
Berkshire Hathaway beat Long-Term Management Capital’s best after-fee performance by a very wide margin, and maintained strong value while LTCM stock plummeted.
Table 4.1 Value of a One-Dollar Investment
Source: Roger Lowenstein, When Genius Failed (New York: HarperCollins, 2002), Pp. 224,225.,Tavakoli Structured Finance, and Yahoo! Finance.
Soon after LTCM’s bailout, John Meriwether started Greenwich-based JWM Partners LLC. Its $1 billion fixed income hedge fund reportedly lost 24 percent in first quarter 2008.7
Berkshire Hathaway continues to exhibit the characteristics most of us look for in a life partner: maximum upside for its size with minimum volatility.
Warren’s mentor, Benjamin Graham, said that speculators should do so with their eyes wide open. When you speculate, you will probably end up losing money. If you want to try it anyway, limit the amount you risk, and separate speculative enterprises from your investment program. Hedge funds, no matter how safe they are made to sound, engage in speculation.
Some hedge funds call themselves “arbitrage” funds, or “quant” funds that perform well in either up or down markets. In reality they are merely hedge funds, and they have risk. If a trade is an arbitrage, you can go long (buy) and short (sell) the identical security in the same time frame and lock in a risk-free return after paying trading commissions. A genuine arbitrage is a money pump. It guarantees a positive payoff with no possibility of a negative payoff and with no net investment. If a hedged trade makes money, then after the fact, it may be tempting to call it an “arbitrage.” To make money, however, historical relationships between your long and short position must remain aligned or must work in your favor. It is much better practice to call a hedge by its real name so that everyone understands you are making a bet, even if it is an educated bet. Many hedge funds that drain investors’ money faster than a blood spurting artery drains your body, proudly—and inaccurately—call themselves arbitrage funds.
A quantitative hedge fund, or a “quant” fund, uses models to perform statistical analyses of historical data.They leverage up market bets when they think something is out of whack with history. They hope observed “anomalies” will revert back to historical levels. The future will not necessarily resemble the past. They know this, but they seem to be so in love with their own math that they brush away any doubts.
Costas Kaplanis, another alumnus of the Liar’s Poker training class, headed arbitrage trading for Salomon Brothers in London and became the head of Global Arbitrage Trading for Citigroup, after it acquired Salomon. Costas complained to me how an “arbitrage” ruined one of his summer trips with his wife, Evi. He was trying to enjoy an al fresco dinner, but he anguished over an interest rate spread trade he had put on. Positions of $1 billion were not unusual if the volatility was “controlled.” The problem with volatility is that it
doesn’t care whether or not you think it is controlled, and the trade had moved against him. He couldn’t eat, he couldn’t sleep, and he couldn’t think.
If you lose sleep worrying about losing money, it is not an arbitrage.
At its Third World Conference of the Bachelier Finance Society in Chicago in 2004, Phelim Boyle, a visiting professor at the London School of Economics, presented work on stochastic volatility models and made an analogy: “Pricing is like falling in love, but a hedge is like getting married.” It sounded catchy and got a laugh. Never one to leave a bad analogy unchallenged, I countered:“A hedge is just a date. If I am going to marry for money, I’ll marry an arbitrage, but I’ll dump a hedge in a heartbeat.”
A genuine arbitrage is a very rare occurrence and technology inefficiencies can be a cause. Lee Argush, the managing partner at Concord Equity Group Advisors, ran a fund that took advantage of a rare information arbitrage opportunity in the new-born Russian currency market exchanges. In the early 1990s, the ruble traded at 200 rubles to the dollar in Moscow, but in St. Petersburg, it traded at 250 rubles to the dollar.The Russian phone system was poor. Even a bandwidth sharing arrangement using excess Soviet military communication lines resulted in numerous communication breaks. (Imagine if there was a real need during the Cold War!) Argush installed Sprint and traded the currency arbitrage.
Since a true arbitrage is so hard to find, I focus on value investing for my personal portfolio in the Benjamin Graham and Warren Buffett tradition.
While Warren Buffett continues to look for value opportunities, all over the globe new money gushes into hedge funds and leveraged investments. We do not care if rich people want to speculate knowing they may lose their money. Unfortunately, many public pension funds and other “safe” investors allocate some of their money to hedge funds.
In 1990 there were a few hundred hedge funds with less than $50 billion in total assets under management. By the summer of 2008, there were around 8,000 hedge funds (depending on who was counting) with $1.87 trillion in assets under management.8 Since hedge funds can only be sold to wealthy investors, they are mostly unregulated based on the flimsy theory that rich investors are sophisticated investors.
Only accredited investors are allowed to invest in hedge funds, but they are pretty easy to find. Regulation D of the Securities Act of 1933 defines an accredited investor as anyone with a net worth—including the value of real estate—in excess of $1 million. If your net worth is not that high, but you have income greater than $200,000 for the past two years—make that $300,000 if you are married—and expected the same this year, you qualify as an accredited investor.
A mere million dollars makes you a high-net-worth individual, but that may not be enough to get you access to the elite hedge funds. Some require a minimum investment of $5 million. Others court the “carriage trade” (old money) and the “caviar crowd” (new money), seeking out ultra-high-net-worth investors worth more than $30 million. In the estimated $1.87 trillion global hedge fund business, fewer than 10 percent of the funds control more than 85 percent of the money.
Banks, savings and loans, and most investment companies qualify as accredited investors. Most trusts with more than $5 million in assets and partnerships also qualify. Many retirement plans, including Employee Benefit Plans, Keogh Plans, and IRAs meet the test. Now there is a happy thought. A pension fund manager can gamble away your retirement money for you, and sometimes they do, especially if their fees are based on “performance.” Money has flooded into hedge funds. High management fees, combined with little regulation of hedge fund managers, is like throwing gasoline on a lit fire.
The easiest way for a hedge fund investor to make a small fortune is to start with a large one. If you are an accredited investor and you are bound and determined to ignore caveat emptor, no one will stop you. Besides, it can be thrilling. But the thrill you experience when you detect a glint of mica—fool’s gold—feels as real as if you had actually struck gold. In the world of hedge funds, there is much mica and little gold.
Theoretically, a hedge fund allows investors to invest in ways that would be difficult on their own. It can amass the funds to make a run at the equity of an undervalued company and take the inevitable regulatory heat. It can study thousands of technical charts to look for a market anomaly and perhaps find an “arbitrage” opportunity. It can take large loan positions in interesting ventures. Theory rarely works out in practice.
When I met Warren in 2005, six of the top 25 highest paid fund managers achieved only single-digit returns, and these are the “successful” hedge fund managers.Yet Edward Lampert of ESL, one of the “sickly six,” earned $425 million in 2005. The top two earners, James Simons of Renaissance Technologies Corp and T. Boone Pickens of BP Capital Management, respectively, earned $1.5 billion and $1.4 billion. Renaissance’s chief fund charges a 5 percent annual management fee, and the managers take 44 percent of the upside, if any exists. In 2007, Jim Simons, Steven Cohen, and Kenneth Griffin each earned over $1 billion.9 Warren Buffett and Charlie Munger each earn a salary of about $100,000 per year, yet their long-term track record has topped these hedge fund managers.10
Many hedge fund managers got into the business because of the incredible success of the legendary Paul Tudor Jones. Tudor Investment Corporation’s $5.7 billion Raptor Global Fund, managed by James Pallotta, had 19.2 percent annual returns since 1993, but when it stumbled a little on U.S. equity investments dropping 8.5 percent by the beginning of December 2007, investors pulled out $1 billion. It is unrealistic to expect that any investment, particularly a hedge fund, will always have a positive return relative to the market. Paul Tudor Jones has had a very successful investment run since 1980 with never a down year until 2007.11 Yet even he does not represent that his funds are safer than the market. Every new hedge fund manager wants to be the next Paul Tudor Jones, George Soros, Jim Rogers, or Ken Griffin. Like Warren, there are true stars who outperform the hedge fund averages, but Warren may sleep better at night.
There is nothing wrong with making a big bet, but one cannot be lulled into thinking that investing in hedge funds is safer than the market. The strategies are so variable that some funds pose much more risk than others. The best can give high performance with few stumbles. Investors may find, however, that at best they have paid high fees to invest with a pale imitation of greatness or a clueless rookie. At worst, they may invest with a crook. Hedge funds have the potential not only to have a zero return—no increase in your capital—for a year, they have the potential to completely wipe out your capital. When you are trying to compound returns, it is fatal to multiply your capital by zero.
I run a hedge fund. My strategy? It’s a proprietary secret. Domicile? It is located onshore in the United States, but the investments are global. There is no lock-up or waiting period for withdrawing an investment from my fund. At the moment it is not leveraged, but sorry, you are not entitled to even that much information.
You won’t find my fund’s returns reported as part of a hedge fund index. Hedge funds do not have to report their returns. You won’t find my fund covered in the financial press, either. What I refer to are not financial products that I market to outside investors. I refer to my personal investment portfolio. Given the low barriers to entry, almost any portfolio of $1 million or more in discretionary investments can call itself a hedge fund.
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.
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 6
