What if Warren Buffet Ran a Hedge Fund?

Funds of hedge funds* type investments are very expensive.

Normally, so expensive that even if all the hedge fund managers in the typical fund of hedge funds were as successful as Warren Buffet was over the last 46 years, investors would still be better off buying a simple index fund.

Let's do the math:

Over the last 46 years**, Warren Buffett as CEO of Berkshire Hathaway has made an average return of 20% per year. Since Mr. Buffett just collected a modest salary almost all of that return went directly to investors.

In hedge fund investments, the fees work very differently:

1. If a hedge fund were successful enough to earn a 20% return, the original hedge fund would typically take fees of about 7% (2% of principal and 20% of profits = 4% + 3.2% = 7.2%) leaving 13%.

2. Then the fund of hedge funds would normally take fees of about 4% (1% of principal and 20% of profits = 1.3% + 2.3% = 3.6%) leaving 9%.

3. Then the distributor may take another 1% and maybe 20% of profits again (1% of principal and 20% of profits = .9% + 1.6% = 2.5%) leaving you with 6.5% before taxes.

4. Assuming you are in the maximum tax bracket, taxes would bring you down to about 4%. Hardly a great return if things go spectacularly well. What if things go badly?

By contrast investing your money in a S&P500 index fund over the same period would have earned you 9.4% per year with only a small tax bite. Simply putting your money in 5 year US Treasury bonds would have earned you 5.4%. And you could get your money out whenever you want.

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* How do funds of hedge funds (FOHF) work? The FOHF is normally organized as a partnership. The managers of the FOHF pool investors money to invest in hedge funds they think will make lots of money in the future. They are often sold through brokers or independent investment advisers. The "pitch" is that they can get you access to the world's best investors. The problem is that even if they get almost everything right, the client won't do very well. The high fees turn what could have been a good investment into a poor one.

** Time period reviewed is 1965-2010

Source: Berkshire Hathaway Annual Report 2010

Thank You Uncle Sam

How soon we forget.

Just two years after a near total economic collapse, the media is rife with complaints about how government intervention failed us and will always fail us. Right now, the topic of the hour is the Fed's very intelligent efforts to inject liquidity into the economy. Only its not described as intelligent. Rather its attacked through internet cartoons and by the likes of Sarah Palin as reckless.

The mood seems to be that if everything isn't good, then we've failed. This is absurd. Yes, unemployment is high and will be for years to come. But an unemployment rate of 9.6% is not an unemployment rate of 20% and GDP growth of 2% is not a contraction of 5%. Things are so much, much better than they would have been without the heroic interventions of 2008.

So it was with a smile on my face that I read Warren Buffett's thank you note to Uncle Sam this morning. Its worth reading to remember and give thanks for a catastrophe averted and for the brave individuals who rose to the challenge.

How to Pick the Investment Strategy that's Right for You

Your most important investment decision is whether to pursue an active or passive investment approach:

With active investing your odds of succeeding range from 0 to 10%. With passive investing, your odds of winning are about 90% after taxes.

So which is right for you?

You can think of active investing as the classic "Buy Low and Sell High" investing strategy. It sounds right until we realize that we are buying and selling from other people who also think they are making a smart decision. And normally these other people -- the ones we are buying and selling from -- are very smart, capable and hard working. We've entered what economists call a zero sum game. In order for one party to win, the other must lose. Then it gets harder. It's not just a matter of half the players winning and the other half losing. Because buying and selling costs both money and taxes, many more people lose than win. After considering transaction costs, about 30% of the players win. After taking out taxes as well, the number of winners falls to 5% - 10%. The rub, however, is that if you do win with active management, you will make more money.

Passive investing is typically a "Buy and Hold" investment approach. It emphasizes diversification and keeping your investments for the long term -- usually decades. The beauty of this approach is that you don't need a sucker at the other end of the trade. Everyone who invests this way can win because as the stock market grows along with company earnings, everyone's investments go up. Because you are not buying and selling, your costs and taxes remain very low.

No one can tell you which approach to take. The answer depends on your appetite for gambling and whether you believe that the 5-10% who win are there by luck or skill.

Said another way: With a $1 million investment, would you prefer a 10% chance of making $120,000 or a 90% chance of making $100,000?

Beware the Roth IRA

... or at least the hype around the Roth. As you will soon learn, starting in 2010 anyone will be able to convert an IRA into a Roth IRA.

The brokerage firms see this as the opportunity of the year. As Fidelity excitingly promotes "With more than $1 trillion in IRAs ... advisers who get to their clients and prospects first ... will gain competitive advantage." The same thing is happening at all the big brokers ... the Roth is being actively promoted as a "no-brainer" for anyone with money to pay the tax now. Its highly likely that in the next few months some-one will try get you to convert your IRA to a Roth.

Simply put a Roth conversion allows you to pay all the tax on an IRA now and then withdraw the funds tax free in retirement.

The argument is that taxes will inevitably rise and so paying them now is just smart. While there are some cases where conversion makes sense, they are relatively rare among people with high current marginal tax rates.

The reason is that your high marginal rate - say 35% federal- is a function of you working and earning several hundred thousand dollars per year. In retirement you stop earning money - and your tax bracket plummets. If you retire with no more than $5 million in investments including IRA's - your federal marginal tax rate probably won't be much more than 15%. Rates would need to go up dramatically before conversion makes sense.

It is possible that you are a good Roth conversion candidate but its not a "no-brainer". Before converting make sure your adviser gives a detailed projection of your taxes in retirement and compare the rates to what you are paying now.

Forecasting is entertainment

Its hard to believe its September already. The weather is perfect, as it normally is in September in Marin, and the markets are ... is this possible ... calm! What a difference from a year ago.

I remember leaving an hour meeting last September and nervously checking the markets: The S&P500 had sunk over 10% during that hour. That's the way it was then. It looked and felt like the end of the world was arriving. Do you remember the forecasts back then - the Dow was going to drop below 3,000 and we were inevitably sliding into another great depression. Six months later the markets would hit bottom amid more talk of doom and gloom. (they've since risen about 35%)

For a while the pundits and forecasters seemed humbled. Virtually no-one had forecast the collapse and the few who had, had been calling for the end for so long, that they just came across as perennial pessimists rather than prescient thinkers. However times have changed. The pundits and forecasters are out again in full force making random and ever changing predictions about our financial future.

The best thing you can do is ignore them.

As Ben Stein explained in a funny article back in March, forecasters and pundits are entertainers - some very good at it - but still entertainers. In terms of making financial decisions, at best they are of no help, and at worst they are truly harmful.

Responsible financial decisions are based on sound, long term principles, not short term guesses.

A 200 Year Flood? Don't bet on it.

For some time now, I've been listening to stockbrokers describe the 2008 Bear Market as a 200 year flood - a freak event that we should assume will never happen again in our lifetimes. The idea is to reassure investors that its safe to stay in or get back into the stock market.

While the 200 year flood is a very comforting metaphor, it's also dangerous, harmful and inaccurate.

The reality is that the recent bear market is one of 5 that saw stocks drop around 50% or more in the last 80 years:

Bear market (how much stocks lost)
2007-2009 (58%)
2000-2002 (49%)
1973-1974 (48%)
1937-1942 (60%)
1929 - 1932 (89%)

On average we have had one of these event every 15-20 years! Hardly a 200 years flood. In fact the last one ended in 2002 - a mere 7 years ago.

So what does this mean for investors?

It means that a critical part of investing is planning for and learning to live with floods: have realistic expectations, at least 3 years of living expenses in cash or AAA short term bonds, and a clear plan for riding out the next storm.

The stock market is still a great investment.

Even with all the corrections and bear markets, it normally delivers returns of about 10% per year. This is great - it means your money would double every 7 years or so! The key is investing with your eyes open and not taking risks you can't afford.

So - Is it safe to buy?

A month ago people were asking if they should sell. Now they are tentatively asking if it’s safe to buy. Why the change of heart? It’s fairly obvious - In the last 30 days or so the stock market is up about 20%. Investing seems a lot safer – as well as a lot more fun - when the market is going up.

So, is it safer to buy after the market has gone up for a month? Actually, yes – at least a little bit. When the stock market is up over a month, there is about a 63% chance it will be up the next month. This compares to only a 58% chance of making money after a down month.

Does this mean you should back up the truck now that the market is up over 30 days and then dump it all after the next down month? After all, a 63% chance of success is better than a 58% chance of success.

Probably not a good idea. Even ignoring how taxes and expenses would eat up the 5% probability difference, you are still almost as likely to lose money as make money. However you look at it, investing on a month- to-month or even year-to-year basis is very risky. There is no way around the reality that you have a very strong chance of losing a lot of money.

Over a 20 year period, however, the stock market becomes a lot safer. If you commit your money for the whole 20 years, you have a better than 95% chance of making money – and that’s a conservative estimate. Including the great depression, there has never been a 20 year period where stocks have actually lost money.

In the end, safety in the stock market comes not from when you buy or sell, but from how long you stay invested.