Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street

by Janet M. Tavakoli

  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 a lot of other mental (or even physical) activities. I also play bridge but I have never played with Buffett.Would I become a better investor if I played bridge with him? Not unless he gave me investment tips at the bridge table.

  One reads about hedge fund squash champions, marathon runners, hang gliders, bikers, and triatheletes. That has nothing to do with whether a money manager will be successful. But I shouldn’t sell sports short. After running a marathon, I had shin splints for three months. It gave me more time to read annual reports, and that is useful when one is managing money.

  It seems that hedge fund managers spring up out of nowhere. Many have addresses in New York, London, Chicago, Los Angeles, and other locations, but sometimes these managers are using the addresses of virtual offices in office buildings that provide a telephone number from which calls are forwarded to the “manager’s” cell phone. It is very easy to create the illusion of a global corporate presence in the age of the Internet. It is even easy to create the illusion of a network of legitimate people.

  Last summer I returned a cell phone call from a “hedge fund manager” who said a professor I know from the University of Chicago’s Graduate School of Business was on his advisory board and the professor suggested he call me. The fellow’s story sounded odd, so I declined to meet with him. I called the professor and asked him how well he knew the man. He admitted to being on the man’s advisory board; but he was about to meet him for the very first time. When I asked the professor why he would lend his name to someone that appeared to operate from a cell phone, he said the man dropped other names and said he had raised $10 million. I told the professor: “I raised $50 million. See how easy it is to say that?” It is also easy to drop names and numbers! While the fellow may be legitimate, the professor had no way of knowing that. It is dangerous to lend one’s name to a total stranger. Warren likes to look people in the eye.

  In June 2005, I was surprised to get an e-mail from Chris Sugrue, then chairman of Plus Funds. He invited me to some hedge fund events organized in concert with the development office at the University of Chicago:

  The University and alumni in the hedge fund industry are working together to provide additional networking and educational events in the future. We’ve put together several hedge fund events over the past two years. . . . Starting July 1, 2005, future hedge fund events will only be open to those who are $2,500+ annual fund [of the University of Chicago] donors.

  Sugrue had an undergraduate degree from the University of Chicago, but did not have an MBA, and somehow had gotten names of Graduate School of Business alumni to solicit. I wrote back to Sugrue asking for an explanation. I said that I found his e-mail solicitation “pretty shameless.” My firm and nine others had already contributed funds to the Finance Roundtable so that students and alumni could attend for free. We gave hedge fund seminars usually discussing the risks; I had given one myself; they were open—and would remain open—to everyone.

  The alarming part was Sugrue’s Plus Funds’ association with Refco, where Sugrue had once been an executive. Plus Funds’ investor money had been commingled with Refco’s in an unregulated account. When Refco filed for Chapter 11 bankruptcy protection on October 17, 2005, Sugrue demanded that the money be moved to segregated accounts, and the money was moved to accounts at Lehman Brothers Holding Inc. Refco creditors naturally wanted the money back. One wonders why the money was not in segregated accounts in the first place. Refco had lent money to Sugrue for various purposes including $50 million, of which $19.4 million went to an entity controlled solely by Sugrue.12

  Court documents state that “Upon information and belief, Sugrue has fled the United States and currently resides in Angola.”13 Angola is a lousy venue for hedge fund conferences. Greg Newton pointed out in his blog, Naked Shorts, that the bad news is Angola does not have an extradition treaty with the United States. The good news is that “[f]oreign nationals, especially independent entrepreneurs, are subject to arbitrary detention and/or deportation by immigration and police authorities.”14 Warren’s Omaha isn’t a grand enough address to feed some hedge fund managers’ ravenous egos. How’s Angola for a swanky address?

  Robert Cialdini, Ph.D., wrote about confidence men in his book, Influence. Grifters know that glitz, honorific titles, and seeming sponsorship of well-known institutions have a powerful influential effect on us, and they do so without any conscious effort on our part. Investment banks tend to lend money just because another investment bank has lent money due to pluralistic ignorance. The second bank to lend will assume the first bank checked out the borrower, and it will skimp on its due diligence. We look around to see what the other guy is doing, and if everyone else is doing it, we go ahead. As Warren Buffett admonished in his letter to his All-Stars, don’t do something just because “everybody else is doing it.”15

  Fortunately, Dr. Cialdini points out that all we have to do avoid being fooled is to make a conscious decision to look for counterfeit social evidence. People can rent virtual offices, expensive homes, flashy cars, and eye-popping jewelry. They can infiltrate the alumni list of a prestigious business school. Question everything. By the way, Robert Cialdini got his Ph.D. in psychology. Did you even question me? But if Cialdini’s Ph.D had been in art history, you would be right to be upset with me for citing him as an expert in psychology.

  Irrational hype should make an investor skeptical as should any claim of intellectual superiority or mystical abilities. Some men seem driven to self aggrandizement. When Father W. Meissner’s psychobiography of St. Ignatius was published in the 1990s, shock waves reverberated through the Catholic Jesuit community. Ignatius was born to a noble Spanish family and aspired to become the paragon of hidalgos; he was a soldier, courtier, and seducer. After a canon ball shattered his leg, Ignatius devoted his energies to founding the Society of Jesus. Meissner claimed he displayed the symptoms of a phallic narcissist: exhibitionism, self aggrandizement, arrogance, unwillingness to accept defeat, and a need for power and prestige. Phallic narcissists can have “counterphobic competitiveness and a willingness to take risks or court danger in the service of self-display.” This “ruthless drive” may give them the “appearance of strength of character and resourcefulness.”16

  In other words, the biography of the saint read like the profile of many a hedge fund manager.

  Alfred Borden, a magician played by Christian Bale in The Prestige, counsels a small boy on the art of illusion: “Never show anyone anything. No one is impressed by the secret. It is what you use it for that impresses.” Borden offers this advice right after showing the lad a cheesy coin trick.

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bsp; Just as a private investment portfolio can maintain secrecy, hedge fund strategies can remain a proprietary secret. Hedge funds that have a “patented” investment strategy or that feel they have a “proprietary” model that only they, “the smartest guys in the room,” have discovered, are probably bad bets. The usual excuse for secrecy is that they do not want someone else to copy their trades or manipulate the market and damage their profits. That was Long-Term Capital Management’s excuse, until it blew up and had to disclose its positions to its creditors. Sometimes there is no strategy other than to employ as much leverage as possible with the hope to get lucky.

  What if the secret strategy means your hedge fund manager invests in a diversified stock index fund portfolio and pays fees of only about 0.1 percent per year while charging you much more? How would you know? Suppose your hedge fund manager thinks the stock market is going to tank. When a hedge fund manager has more than $1 billion in funds under management, he can invest in virtually risk-free T-bills and do well for himself with a 2 percent management fee. In a down market, he can claim victory with even a small positive performance. How long would it take investors to figure it out they are paying hedge fund fees for T-bill performance and pull out? Remember, the strategy must stay secret.

  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 poorer overall decision-making ability. Studies showed individuals would take 50-50 bets in which they could win 1.5 times more than they would lose, but people with sound minds would not take the bet unless they had a 50-50 chance of winning twice as much as they might lose. A few business school professors suggested that the brain-damaged people would make better investors. For example, brain-damaged hedge fund managers might accept a 50-50 chance of winning $3 billion versus losing $2 billion, whereas a hedge fund manager of sound mind might not accept the bet unless he had a 50-50 chance of winning $4 billion versus losing $2 billion.

  The problem with that reasoning, as hedge fund after hedge fund has discovered, is that the market has uncertain outcomes and the probabilities are unknown in advance. In such circumstances, making riskier bets does not show superior decision-making ability, it just means the fund manager is happy to accept a lower margin of safety.

  Even the hedge fund manager of “sound mind” can be wiped out on a series of bets that have a 50-50 chance of winning $4 billion versus losing $2 billion. John Maynard Keynes warned: “The market can stay irrational longer than you can stay solvent.”18 Warren Buffett is even more risk averse than the hedge fund manager of “sound mind.”Yet he is the best investor in the last century—perhaps in the history of mankind—disproving the theory of efficient markets, a pet theory of many business school professors. “You can occasionally find markets that are ridiculously inefficient,” Warren points out, or “…you can find them anywhere except at the finance departments of some leading business schools.”19

  In his book Innumeracy, mathematician John Allen Paulos gives many examples showing human beings are not good at assessing probabilities without formal training.We like to explain random events after-the-fact as if we predicted the outcomes. Many hedge funds are successful simply because of lucky bets. If the bets randomly pay off and the fund has a great year, the lucky fund manager takes credit for being a genius.When Nassim Nicholas Taleb, a risk theorist, discusses Buffett’s success, he seems to damn it with faint praise: “I am not saying that Warren Buffett is not skilled; only that a large population of random investors will almost necessarily produce someone with his track records just by luck.”20 If Taleb needed an example of success due to random luck, he did not choose well; he could have chosen from any number of hedge funds instead. Taleb fails to mention conditional probabilities (in this context), and it is remiss to describe Warren’s success without bringing that up. Certainty is not possible, and luck is always a part of the equation, but Warren works hard to uncover a margin of safety whenever possible.

  What is the probability of a successful investment, given that one has a sound methodology for analyzing a business? It is much better than the probability of success without the sound methodology, and the probability of disaster is very low. In contrast, a one-sided leveraged bet presents an altogether different conditional probability.What is the probability of a disaster, given that one has merely leveraged a market bet? If one is lucky one will do well, but if one is unlucky—or simply flat out wrong from not doing one’s homework—the probability of disaster is about 100 percent.

  I sent Warren a client note in September 2006 in which
I made a similar point after the Amaranth hedge fund imploded after losing its shirt on natural gas contracts.The hedge fund leveraged up a bet and the bet (on natural gas spreads) went against them. It was a classic Dead Man’s Curve trade: “The last thing I remember, Doc, the market started to swerve.”21 Unlike Warren Buffett, Amaranth had no margin of safety. Warren wrote back: “You both think and write well.”22 Since meeting Warren, I’ve found myself comparing every trade against value investing.

  A man once asked the late Richard Feynman, a Nobel Prize- winning physicist, how he would design an anti-gravity machine.When Feynman replied he could not, the man pointed out that it would solve the world’s problems. Feynman said it didn’t matter, he didn’t know how to do it. Many investors seem to hope that hedge fund managers have designed a strategy that uses leverage to create profits that will forever defy gravity. Yet Warren Buffett will be the first to admit that even he cannot design the financial equivalent of the anti-gravity machine.

  Most hedge fund managers happily load up on risk to stay in the game. Hedge fund wisdom is “heads I win, tails you lose, and I still win—just not as big.”There is one other possibility:The coin can stand on edge—the hedge fund manager gets bailed out, and you give back your winnings, but we will get to that later. For now, winning means that a hedge fund’s returns are up, managers collect hefty fees while attracting new money, and investors get a reasonable return on their money. Losing means that hedge fund managers still make hefty fees and investors have a negative return or perhaps even lose all of their money.The hedge fund manager hates to lose, since he will not be able to attract new money and the money, upon which he gorges, will shrink, thus decreasing his payday.