Hedge funds make perfect sense for people who want to hedge their capital in specific ways. A hedge fund doesn't need to outperform the market to deliver tremendous value to their customers.
Secondly, every trade has a counterparty. So somebody necessarily has to be at the loser's end of every trade. For every investment fund that makes oversize profits another fund loses money. It all evens out. That doesn't mean it's entirely zero sum, though, because money still flows from bad businesses towards good businesses as a result. The incentives for professional money managers are also totally misaligned: funds performance is reported quarterly leading to a short term bias; fund managers get a bonus if they invest irresponsibly but get lucky; customers are unsophisticated so it's one big lemon market.
I agree that index funds make a lot of sense for non-millionaires (and single digit millionaires), but that's simply because it takes a lot of effort to beat the market even by a few percent so you need a lot of assets for it to be worthwhile.
> That doesn't mean it's entirely zero sum, though, because money still flows from bad businesses towards good businesses as a result.
Buffet's point is that it's negative-sum. A gambler might win today, but lose tomorrow, and his counterparty will get the opposite, but the house wins on every transaction. While the players churn, the market makers and rent seekers will drain the system of money, in aggregate.
You're reading it incorrectly. Buffett is making the claim that people have "waste[d] more than $100 billion over the past decade" looking for superior investment returns. That's his claim, no more. And I agree.
There wouldn't be a stock market if everybody just invests in a fortune 500 index fund. The benefit to society of a functioning stock market is way more than $10B/yr.
No, he isn't reading it incorrectly. Buffett is claiming that on aggregate, because of the fees, the passive investors will be better off than the active investors.
From page 23:
A lot of very smart people set out to do better than average in securities markets. Call them active investors.
Their opposites, passive investors, will by definition do about average. In aggregate their
positions will more or less approximate those of an index fund. Therefore, the balance of
the universe—the active investors—must do about average as well. However, these
investors will incur far greater costs. So, on balance, their aggregate results after these costs
will be worse than those of the passive investors.
Yes, but Buffett is not claiming that active investing (as opposed to passive index investing) is negative-sum in aggregate! That would be ludicrous, because Buffett is an active investor himself and the Buffett Annual Report is a long form sales letter to persuade people to buy more Berkshire shares.
Buffett, as an active investor, can outperform the market, while active investors as an aggregate might not. I fail to see any ludicrousness.
> Buffett Annual Report is a long form sales letter to persuade people to buy more Berkshire shares.
Nonsense. Buffett doesn't care one whit about people buying more Berkshire Hathaway shares. If anything, he wouldn't mind people selling shares and driving the price down to below 1.2 x book value, so he can buy them back at a discount.
If active investment were negative-sum in aggregate then society would be better off if there were no active investors at all and everybody would invest in passive index funds instead. Unfortunately you need active investors to keep the market honest, without active investors index funds wouldn't work!
Index funds are needed so investment funds don't overcharge their customers, and investment funds are needed to keep the market honest.
It makes sense for individuals (or institutions) to invest in index funds, but only up to a point. When too much money is stuck in passive index funds the active investors will easily outperform the market and the smart money will leave the index funds again.
The person I was responding to was drawing an analogy to a casino where the money just moves around and the institutions just skim every time money changes hands. That's negative sum. In contrast, society benefits when the stock market gives access to capital to well run companies and takes money away from poorly run companies. So the casino analogy doesn't work. Buffett understands that the stock market as a whole isn't zero sum (or negative sum), and that's true even if all investment firms in aggregate underperform the indexes.
Investing in the stock market is secondary to the actual investment into activities performed by the companies that constitute it.
Thus, investments decisions made within such companies are those that promote their growth (or not).
In this manner, without insider knowledge into the internal decisions those companies make, and thus the ability to judge the viability of their investments, investing in something other than a stock index is much riskier. But the stock market itself can still grow.
The distinction is that investing in "the market" is an arms length investment that occurs well after the good or bad investments that affect the profitability of individual companies have occurred.
I think you and your interlocutors are talking past each other. It's true (and fashionable to point out) that active investment is what makes price discovery, and thus the markets themselves, work. But that doesn't make it a good idea to invest in hedge funds or any other active investment vehicles. Just as Buffett describes earlier in the letter w/r/t the insurance business, active investors can compete the returns on effective price discovery down below the returns on passive investing.
Maybe over the long term the returns on active investing will simply go to prop traders.
Perhaps it is fashionable to point that out where you live, but common wisdom I hear is "everybody should just use index funds", without stopping to ask what would happen if everybody actually did.
Worldwide equities are 65 trillion or so. Can you have a functioning stock market if 1T of that is actively managed by prop traders and the remaining 64T is in passive index funds? I'm not so sure.
Now you're talking past me. It does not follow from the fact that active investment is necessary that people should invest with active investors. Again, fierce competition among active investors can --- and probably have --- created conditions where all the returns on active investing will go to (effectively) proprietary traders.
I don't think I'm talking past you -- your previous point was perfectly clear. You literally cannot have active investments if nobody invests with active investors or actively manages their funds themselves. This is tautological. So somebody has to invest with active investors, but Buffett is arguing it should be somebody else and not you.
If 99.99% of all assets are locked up in buy-and-hold passive index funds the prop traders can't do anything when a stock is mispriced because they can only trade with the handful of active investors that remain. With 65 trillion in equities a handful of prop traders can jump high and low all they want but the markets won't budge if nobody is buying or selling. The index managers on the other hand will be able to move markets with a keystroke, because whenever they decide that one stock in the index has to be replaced by another all the index fund money blindly follows.
You're now litigating the literal definition of a prop trading firm.
Nobody is arguing that you shouldn't start a prop trading firm. The argument is that you shouldn't invest in hedge funds, because passive investment funds outperform them. If you want to make money in active investment, join or form a prop firm.
The broader point would be, the market can probably function based on passive investment and inputs from prop firms, without retail and institutional investors ever needing to engage in active investment. That would also be compatible with the notion that active trading is in general unprofitable because the profit is so aggressively competed out of it.
I literally made this point earlier. I even used the word literally to indicate I meant it literally.
> Nobody is arguing that you shouldn't start a prop trading firm.
I disagree. People are absolutely arguing that nobody should start a prop firm because you can't beat the market. That the prop funds that succeed are just those that have gotten lucky in the short term. That everybody should put their money in index funds instead. I know you don't believe this, but it's a common belief for sure.
I think that if all retail investors and all institutional investors exclusively invest in passive funds the market will get out of whack. We're talking about all pension funds, university endowments, private trusts, all moving to index funds. All households together own about 80% of the stock market (direct + indirect ownership). Hedge funds another 4%. Prop trading firms probably less than 1%. There are over 3500 publicly listed US equities and another 10,000 OTC. Deep analysis on every equity is needed to determine if it is fairly valued; no way prop firms can take on this gargantuan task by themselves.
Not to mention that index funds are long-only. Very few hedge funds are. If almost everybody moved to index funds the long-only bias by itself could be disastrous.
Like I said, I wasn't say you were wrong, I was saying that you and your interlocutors were talking past each other. It can simultaneously be true that active investors can "beat the market" and that retail and institutional investors shouldn't invest in actively-managed funds.
The place I think we got hung up here is on the notion of "nobody investing in", because obviously a person who starts or joins a prop trading firm is in a sense investing in that firm.
It can be true, but my point is that it probably isn't true. And I've explained why I think this. You can look at passive investing as defecting in a large game of prisoner's dilemma (tragedy of the commons). With passive investing you enjoy the benefits of an efficient market without doing any analysis yourself (or paying for somebody else to do it on your behalf). So you can advise every individual to defect (because it's in their best interest) but if too many people defect the system breaks down.
So when you say "It can be true that [...] retail and institutional investors shouldn't invest in actively-managed funds", that can mean two totally opposite things, as hopefully you can now see. That's why we talk past each other. I also suspect there is a real disagreement about what the impact of index funds will be in the long term.
> Buffett Annual Report is a long form sales letter to persuade people to buy more Berkshire shares.
If you have read his past reports you will know that he wants his shareholders (he calls them partners) not to sell their shares. He published some numbers in the past as well where 90% of shareholders don't sell and he is very happy about that.
Suppose you're a business with a lot of positive cash flow, but you also have a lot of exposure to the USD-MXN exchange rate. Maybe you have factories in Mexico but sell to the US, it doesn't matter. In that case you can pay a hedge fund to hedge your money so that if the exchange rate collapses you make enough money on the stock market to compensate, so your business will survive until the exchange rate climbs back.
Most businesses have very high exposure to one section of the market, so wanting to hedge is natural. If your business makes toilet paper you have it easy because no matter what happens demand for your product won't collapse overnight. If you make cars then economic recessions are scary because new car sales will drop like a brick, and you need to hedge.
Most hedge funds have very little to do with the kind of hedging you describe.
If you had that kind of exposure to currency risks, you wouldn't go to a hedge fund. You can easily hedge that risk yourself with futures or options. If you wanted to pay somebody for it, you would go to your banker and he would do it for you for a fraction of the 2/20 fees charged by hedge funds.
The average banker has no idea how to hedge any serious amount of money, nor does the average banker understand what kind of hedging strategy is appropriate for a business. Nothing about hedging with futures or options is easy. Also, hedge funds don't charge 2/20 anymore like in the good old days.
Nonsense. Futures and options and how to use them to hedge exchange rate risks are covered in any good masters in finance (source: I have a masters in finance). You don't even need any advanced math (the ancient Greeks were using options to hedge their olive harvests).
The bank teller might not know about them, but the bank most assuredly has people that can help you.
Also, contrary to what your posts suggests (any serious amount of money), the amount of money has no bearing on how you would hedge its risk.
According to the Shareholder's Letter, the 5 funds of funds in the bet portfolio were comprised of funds that largely did charge 2/20, with the fund-of-fund charging an addition 1% plus performance on top of that.
> The notion that hedge funds all collect a stereotypical management fee of 2 percent and a performance fee of 20 percent has been dying a slow death in recent years, especially for smaller, newer funds.
I said 2/20 fees aren't the norm anymore. You quoted from the letter. I provided a source that shows hedge fund fees are going down and remarked that the Buffett bet started before the 2008 crash when fees were higher then they are now. Because it was a boom period and because index funds that push down management fees have only recently become popular.
It seems to be that either Buffett must be mistaken or you are, right? His claim is that the funds involved in the bet are 2/20 funds, and while the bet started in 2008, it is still running today.
Technically, he claims they pay less than 2/20 but no details are provided. Nowadays 2/20 fees are considered high, not the norm. Fees are trending down. This is something you can easily verify. Buffett did say 2/20 is the "prevailing hedge-fund standard" but he's mistaken.
I guess. Mostly, I've just been nerdsniped by the claim you made that the timing of the bet could invalidate it's claim. It's a 10-year bet, so Buffett has in fact maximized his exposure to the phenomenon you describe.
>Secondly, every trade has a counterparty. So somebody necessarily has to be at the loser's end of every trade.
This is not true. There will always be someone who wins less between the two, but it doesnt mean it wasnt a win-win trade. Some things are more valuable to one person than another.
Secondly, every trade has a counterparty. So somebody necessarily has to be at the loser's end of every trade. For every investment fund that makes oversize profits another fund loses money. It all evens out. That doesn't mean it's entirely zero sum, though, because money still flows from bad businesses towards good businesses as a result. The incentives for professional money managers are also totally misaligned: funds performance is reported quarterly leading to a short term bias; fund managers get a bonus if they invest irresponsibly but get lucky; customers are unsophisticated so it's one big lemon market.
I agree that index funds make a lot of sense for non-millionaires (and single digit millionaires), but that's simply because it takes a lot of effort to beat the market even by a few percent so you need a lot of assets for it to be worthwhile.