This article was published by The McAlvany Intelligence Advisor on Wednesday, March 1, 2017:
In the latest shareholder letter just released by Berkshire Hathaway, Warren Buffett brought his fans up to date on “The Bet.” On its face it seems simple: Buffett was willing to bet good money that any S&P 500 index fund would beat, over a period of time, the performance of the best money managers in the business. But no one took him up on his wager:
Now, to my bet and its history. In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund.
Initially he offered to wager $500,000 that no investment professional could select a group of at least five hedge funds that would, over a period of time, beat the returns on an unmanaged S&P 500 index fund charging only token fees:
What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge….
Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager.
There were fees galore, fees upon fees, all designed, it is said, to “incentivize” the managers:
Each fund-of-funds, of course, operated with a layer of fees that sat above the fees charged by the hedge funds in which it had invested. In this doubling-up arrangement, the larger fees were levied by the underlying hedge funds; each of the fund-of-funds imposed an additional fee for its presumed skills in selecting hedge-fund managers.
The results? From the start of 2008 the best of the five funds that Seides selected returned, through 2016, 62.8 percent. The worst returned just 2.9 percent.
And Buffett’s S&P 500 index fund of choice – the Vanguard S&P index fund? It returned 85.4 percent.
Seides probably ought to cash in, pay up, and hope people forget. If the bet continues to run, the gap is likely to get even larger.
But some people never learn. That would include the brand new CEO at Harvard Management Company (HMC), N.P. “Narve” Narvekar. He was brought in last December – the eighth in the last 10 years – to rescue Harvard’s $35 billion endowment from its years-long run of ghastly performance. Last year Berkshire Hathaway’s investors enjoyed a 23.4 percent return, while Harvard’s endowment fund dropped by two percent, below where it was in 2008.
“Narve” cleaned house: he cut the 230-person staff in half, wishing those departing well: “It is exceptionally difficult to see such a large number of our colleagues leave the firm, and we will be very supportive of these individuals in their transition. We are grateful for their committed service to Harvard and wish them the very best in their future endeavors.”
Next he told his traders to close their accounts as part of his plan to ship most of the fund’s liquid assets to off-site hedge fund managers, just the type of people Buffett was railing against. For his efforts “Narve” will receive $9 million a year for five years with a three-year guarantee (just like in the NFL). He made sure that the transition wouldn’t produce the desired results right away:
Major change is never easy and will require an extended period of time to bear fruit. Transitioning away from practices that have been ingrained in HMC’s culture for decades will no doubt be challenging at times.
But we must evolve to be successful, and we must withstand the associated growing pains to achieve our goals.
The company’s performance was so bad that consulting firm McKinsey & Company was brought in to find out what the matter was and to recommend changes. According to Bloomberg, which had a look at the report, which wasn’t made public, employees at HMC complained of an “inattentive board” and a “complacent culture,” calling upper management “lazy, fat, and stupid.”
McKinsey found that during the five years from 2000 to 2014, the compensation for individual account managers soared while the fund’s performance languished. Eleven money managers for HMC raked in $242 million, 90 percent of which was made up of bonuses for outperforming their “benchmarks.” One of the authors of the report said, “This is the only place I’ve seen where people can negotiate the benchmark they get compensated on!” As a result, said McKinsey, those benchmarks were “easy to beat, inconsistent, and often manipulated.”
According to Bloomberg, the performance failure cost the school’s endowment $3.5 billion. In other words, the fund, worth about $35 billion today, should be worth closer to $40 billion, perhaps even more.
In other words, the managers got performance bonuses while the fund was underperforming.
Buffett had this to say about that:
I’m certain that in almost all cases the managers [of the hedge funds competing against his Vanguard index fund] at both levels were honest and intelligent people. But the results for their investors were dismal – really dismal. And, alas, the huge fixed fees charged by all of the funds and funds-of-funds involved – fees that were totally unwarranted by performance – were such that their managers were showered with compensation over the nine years that have passed. As Gordon Gekko might have put it: “Fees never sleep.”
If Harvard weren’t such a breeding ground for leftists and totalitarians who successfully insinuate themselves into Washington, D.C., colleges, and political action groups funded by billionaires, one could almost feel sympathy for the beneficiaries of its endowment fund. It funds a third of the university’s budget, most of its scholarships, and a bevy of research projects.
On the other hand, just think how much more damage Harvard could do to the republic if its endowment had performed as well as the S&P. It might be worth $50 billion, or more!
Harvard Gazette: Course change for Harvard Management Company