“The Bet” received considerable media attention following the 2017 Berkshire Hathaway shareholder letter in 2018.
To recap, the bet was between Warren Buffet and Protégé Partners, who picked five “funds of fund” hedge funds they expected would outperform the S&P 500 Index over the 10-year period ending December 2017. Buffet took the S&P 500 to outperform.
The bet was made in December 2007, when the market was reasonably expensive and the Global Financial Crisis (GFC) was just around the corner.
Buffet won. The S&P 500 easily outperformed the Hedge Fund selection over the 10-year period.
There are some astute investment lessons to be learnt from this bet, which are very clearly presented in this AllAboutAlpha article, A Rhetorical Oracle, by Bill Kelly.
Before reviewing these lessons, I’d like to make three points:
- I’d never bet against Buffet!
- I would not expect a Funds of Funds Hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Funds.
- Most if not all, investor’s investment objective(s) is not to beat the S&P 500. Investment Objectives are personal and targeted e.g. Goal Based Investing to meet future retirement income or endowments
This is not to say Hedged Funds should not form part of a truly diversified investment portfolio. They should, as should other alternative investments.
Nevertheless, I am unconvinced Hedge Fund’s role is to provide equity plus like returns.
By and large, alternatives, including Hedge Funds, offer a less expensive way of providing portfolio protection as their returns “keep up” with equities, see the previous Kiwi Investor Blog Sharemarket crashes – what works best in minimising losses, market timing or diversification.
One objective in allocating to alternatives is to add return sources that make money on average and have low correlation to equities. Importantly, diversification is not the same thing as “hedging” a portfolio
Now, I have no barrow to push here, except advocating for the building of robust investment portfolios consistent with meeting your investment objectives. The level of fees also needs to be managed appropriately across a portfolio.
In this regard and consistent with the points in the AllAboutAlpha article:
- Having a well-diversified portfolio is paramount and results in better risk-adjusted returns over time.
Being diversified across non-correlated or low correlated investments is important, leading to better risk-adjusted outcomes.
Adding low correlated investments to an equities portfolio, combined with a disciplined rebalancing policy, will likely add value above equities over time.
The investment focus should be on reducing portfolio volatility through true portfolio diversification so that wealth can be accumulate overtime.
Minimising loses results in higher returns over time. A portfolio that falls 50%, needs to gain 100% to get back to the starting capital. This means as equity markets take off a well-diversified multi-asset portfolio will not keep up. Nevertheless, the well diversified portfolio will not fall as much when the inevitable crash comes along.
It is true that equities are less risky over the longer term. Nevertheless, not many people can maintain a fully invested equities portfolio, given the wild swings in value (as highlighted by Buffett in his Shareholder Letter, Berkshire can fall 50% in value).
100% in equities is often not consistent with meeting one’s investment objectives. Buffet himself has recommended the 60/40 equities/bond allocation, with allocations adjusted around this target based on market valuations.
I am unlikely to ever suggest to be 100% invested in equities for the very reason of the second point in the article, as outlined below.
- Investment Behavioural aspects.
How many clients would have held on to a 100% equity position during the high level of volatility experienced over the last 10-12 years, particularly in the 2008 – 2014 period. Not many I suspect. This would also be true of the most recent market collapse in 2020.
The research is very clear, on average investors do not capture the full value of equity market returns over the full market cycle, largely because of behavioural reasons.
A well-diversified portfolio, that lowers portfolio volatility, will assist an investor in staying the course in meeting their investment objectives.
An allocation to alternative strategies, including a well-chosen selection of Hedge Funds, will result in a truly diversified Portfolio, lowering portfolio volatility. See an earlier Post, the inclusion of Alternatives has been an evolutionary process, not a revolution.
Staying the course is the biggest battle for most investors. Therefore, take a longer-term view, focus on customised investment objectives, and maintain a truly diversified portfolio.
This will help the psychological battle as much as anything else.
I like this analogy of using standard deviation of returns as a measure of risk. It captures the risks associated with a very high volatile investment strategy such as being 100% invested in equities:
“A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”
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