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What He Said...Why Hedge Funds Fail

Posted: October 23, 2015 | by: Thomas F. McKeon, CFA

Warren Buffet tells it like it is in a recent post on MarketWatch: Why Hedge Funds Fail (to serve investors).

In a post written by Mitch Tuchman on MarketWatch from October 17th, the Oracle of Omaha talks about the inherent bias of the hedge fund model that serves the hedge fund operators at the expense of the clients. He also speaks about how fee structures on down the retail food chain do essentially the same thing, charging too much and delivering too little net return to the investors.


From the article:

You might be surprised to see occasional headlines bemoaning the poor performance of hedge funds versus the market indexes. Not Warren Buffett.

Hedge fund managers serve two masters: their clients and themselves. That sounds like a solid alignment of interests, but it's not, the billionaire investor says. That's because hedge fund chiefs get paid win or lose.

The fixed annual fees hedge funds charge are the real money-makers, not the contractual "bonuses" for performance. By extension, Buffett is making a statement about active managers of all kinds. They're not in the business of beating the market. They're in the business of attracting assets and that's all.

For example, a hedge fund managing $1 billion charges a fee of 2% of those assets per year plus 20% of trading profits. Let's assume the fund breaks even — no profits. That's still $20 million in fees. When a hedge fund controls $20 billion, the income is $400 million.


Buffet cautions that expenses are too high all along the food chain and calls the rent-seekers "Grifters." 

But the same process Buffett warns about — short-timers trying to grift the system — is endemic across the retirement world, too. Your 401(k) plan doesn't hit you for 20% of profits. But it almost certainly collects close to a 2% annual fee (or worse) and that's all that matters. Your IRA plan fees seem okay at 1% a year. Do you realize that the underlying funds in your plan cost you another 1% or more? Your costs are well into hedge fund territory.


The Inescapable Conclusion

Lowering fees is the answer. Stocks and bonds do what they do. Prudent, low-cost management captures the lion's share of those gains. High-cost, actively managed fund salesmanship, meanwhile, achieves the polar opposite.

We could not agree more.


Click here to read the entire post on MarketWatch .

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