Buffett Berates Hedge Funds; Is He Right?

Although Warren Buffett’s reputation as one of the all-time greatest stock market investors seems beyond reproach, in recent years there have been whispers on Wall Street that the “Oracle of Omaha” has lost his magic touch.

Now 86 years old, Buffett adheres to a buy-and-hold approach to beating the stock market that some investment hot shots view as simplistic and outdated. Among Buffett’s belittlers are hedge fund managers, who weave in and out of portfolio holdings using sophisticated trading technology to inform their decisions.

And yet, the proof is in the performance. In 2016, Buffett’s Berkshire Hathaway (NYSE: BRK-A) investment company was up nearly 23.4%, about twice the return of the S&P 500. Consequently, when Buffett released his annual shareholder letter this week to discuss last year’s excellent results, he did not miss the opportunity to take a swipe at his naysayers.

Advising investors of all sizes to “stick with low-cost index funds,” Buffett singled out hedge funds for charging exorbitant fees while delivering sub-par returns.

Who can blame him? Buffett has patiently defended his methodical approach to building wealth over a long period of time, while watching hedge fund managers earn enormous fees for jumping from one hot stock to the next with little regard to long-term consequences.

Despite his gregarious nature, Buffett could not hide his contempt for these managers in his annual shareholder letter:

“A hedge fund operator’s ability to simply pile up assets under management has made many of these managers extraordinarily rich, even as their investments have performed poorly.”

Although Buffett is correct in his assertion, his statement belies the secret to his success. To the extent one investor under-performs the overall market average, another investor must be outperforming it by the same amount (after subtracting management fees from the equation). That means those same bad decisions made by hedge fund managers are capitalized on by other investors who, like Buffett, profit at their expense.

So it is with crocodile tears that Buffett disparages the very people upon whom he has feasted over the past 50 years. If everyone really did take his advice and put all their money in index funds, then Buffett would have no one from whom to extract his outsized returns. He can make that disingenuous recommendation knowing that there will always be a new generation of greedy investors looking for a shortcut, constantly providing a supply of mis-priced stocks for him to buy at bargain prices.

In fact, I had Buffett in mind when I created my IDEAL Stock Rating System.

My IDEAL system’s sole objective is to identify stocks within the S&P 500 that are more likely to perform better than the index average in the coming year. By measuring three fundamental variables — dividend yield, cash flow and relative valuation — it shows the extent to which an individual stock is trading at a premium or discount to the overall market after being normalized for those elements.

My system isn’t perfect, but it doesn’t need to be to produce outstanding long-term results, as long as the winners outweigh the losers.

Buffett himself owns up to imperfect decisions over the course of his career in his annual letter, which leads off with a year-by-year performance comparison of Berkshire Hathaway stock to the S&P 500. He reveals that in 1971 the index lost 26.4%, while shares of Berkshire declined by a whopping 48.7%. However, five years later Berkshire gained 102.5% versus an increase of 18.2% for the S&P 500.

Left unsaid in Buffett’s letter, but clearly implied, is that if you want to beat the market over time, you must own individual securities to do it, just as he has done. Although Buffett says he advocates the use of index funds to friends who ask for investment advice, apparently he doesn’t follow that practice himself. Nowhere in the list of portfolio holdings for the business that made him one of the richest people in the world will you see an S&P 500 index fund.

I’m sometimes asked why I don’t recommend index funds in the Personal Finance Growth Portfolio, and my answer is simple: If you want average results, you don’t need to read our newsletter, nor anyone else’s for that matter. Buy an index fund.

However, if you want to emulate Buffett and outperform, owning an index fund won’t do that for you. It’s that simple.

Final note: Warren Buffett’s net worth currently stands at $76.5 billion, which (as far as we’re concerned) gives his views a lot of credibility.