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

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?

Index funds win again

Yet another study confirms that investments in index style funds beat hedge funds and mutual funds run by supposed investment geniuses - by a shockingly wide margin. This is especially true for wealthier investors paying taxes at the highest levels. Mark Kritzman of Windham Capital Management shows that for a New York State taxpayer, an index fund returning just 10% annually beats a typical hedge fund returning 19% per year and an active mutual fund returning 13.5% per year. The results are even more startling in California where we pay a state tax of 9.25% (and growing) compared to NY State's 6.85%.

This means that a hedge fund would need to beat the index fund by 10 percentage points every year and the active fund by 4 percentage points. Finding such funds is almost impossible since so few exist. And the very few that do have a record of winning by such wide margins are almost certainly there by luck.

Once again we find that on Wall Street, the bigger the story, the worse the results.