Keeping Perspective: Julian Robertson’s Last Letter to Investors

Growth stocks — and specifically large-cap tech stocks led by the FAANGs — have utterly crushed value stocks of late. It’s been the dominant theme of the past five years. Even the first quarter of 2018, which saw Facebook engulfed in a privacy scandal, saw growth outperform value.

SectorBenchmarkQtr. Return
Large-Cap GrowthS&P 500 Growth1.58%
Large-Cap StocksS&P 500-1.22%
InternationalMSCI EAFE Index-2.19%
UtilitiesS&P 500 Utilities-3.30%
Large-Cap ValueS&P 500 Value-4.16%
Real Estate Investment TrustsS&P U.S. REIT Index-9.16%
Master Limited PartnershipsAlerian MLP Index-11.22

Value stocks in general underperformed, and the cheapest of the cheap — master limited partnerships — got utterly obliterated.

So, is value investing dead?

Before you start digging its grave, consider the experience of Julian Robertson, one of the greatest money managers in history and the godfather of the modern hedge fund industry. Robertson produced an amazing track record of 32% compounded annual returns for nearly two decades in the 1980s and 1990s, crushing the S&P 500 and virtually all of his competitors. But the late 1990s tech bubble tripped him up, and he had two disappointing years in 1998 and 1999.

Facing client redemptions, Robertson opted to shut down his fund altogether. His parting words to investors are telling.

The following is the Julian Robertson’s final letter to his investors, dated March 30, 2000, written as he was in the process of shutting down Tiger Management:

In May of 1980, Thorpe McKenzie and I started the Tiger funds with total capital of $8.8 million. Eighteen years later, the $8.8 million had grown to $21 billion, an increase of over 259,000 percent. Our compound rate of return to partners during this period after all fees was 31.7 percent. No one had a better record.

Since August of 1998, the Tiger funds have stumbled badly and Tiger investors have voted strongly with their pocketbooks, understandably so. During that period, Tiger investors withdrew some $7.7 billion of funds. The result of the demise of value investing and investor withdrawals has been financial erosion, stressful to us all. And there is no real indication that a quick end is in sight.

And what do I mean by, “there is no quick end in sight?” What is “end” the end of? “End” is the end of the bear market in value stocks. It is the recognition that equities with cash-on-cash returns of 15 to 25 percent, regardless of their short-term market performance, are great investments. “End” in this case means a beginning by investors overall to put aside momentum and potential short-term gain in highly speculative stocks to take the more assured, yet still historically high returns available in out-of-favor equities.

There is a lot of talk now about the New Economy (meaning Internet, technology and telecom). Certainly, the Internet is changing the world and the advances from biotechnology will be equally amazing. Technology and telecommunications bring us opportunities none of us have dreamed of.

“Avoid the Old Economy and invest in the New and forget about price,” proclaim the pundits. And in truth, that has been the way to invest over the last eighteen months.

As you have heard me say on many occasions, the key to Tiger’s success over the years has been a steady commitment to buying the best stocks and shorting the worst. In a rational environment, this strategy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much.

The current technology, Internet and telecom craze, fueled by the performance desires of investors, money managers and even financial buyers, is unwittingly creating a Ponzi pyramid destined for collapse. The tragedy is, however, that the only way to generate short-term performance in the current environment is to buy these stocks. That makes the process self-perpetuating until the pyramid eventually collapses under its own excess. [Charles here. Sound familiar? Fear of trailing the benchmark has led managers to pile into the FAANGs.]

I have great faith though that, “this, too, will pass.” We have seen manic periods like this before and I remain confident that despite the current disfavor in which it is held, value investing remains the best course. There is just too much reward in certain mundane, Old Economy stocks to ignore. This is not the first time that value stocks have taken a licking. Many of the great value investors produced terrible returns from 1970 to 1975 and from 1980 to 1981 but then they came back in spades.

The difficulty is predicting when this change will occur and in this regard, I have no advantage. What I do know is that there is no point in subjecting our investors to risk in a market which I frankly do not understand. Consequently, after thorough consideration, I have decided to return all capital to our investors, effectively bringing down the curtain on the Tiger funds. We have already largely liquefied the portfolio and plan to return assets as outlined in the attached plan.

No one wishes more than I that I had taken this course earlier. Regardless, it has been an enjoyable and rewarding 20 years. The triumphs have by no means been totally diminished by the recent setbacks. Since inception, an investment in Tiger has grown 85-fold net of fees; more than three time the average of the S&P 500 and five-and-a-half times that of the Morgan Stanley Capital International World Index. The best part by far has been the opportunity to work closely with a unique cadre of co-workers and investors.

For every minute of it, the good times and the bad, the victories and the defeats, I speak for myself and a multitude of Tiger’s past and present who thank you from the bottom of our hearts.

Charles here. The more things change, the more they stay the same. Value will have its day in the sun again, and that day is likely here with the FAANGs finally starting to break down.

Had Robertson held on a little longer, he would have been vindicated and likely would have made a killing. Consider the outperformance of value over growth in the years between the tech bust and the Great Recession:

 

So, don’t abandon value investing just yet. If history is any guide, it’s set to leave growth in the dust.

 

 

This article first appeared on Sizemore Insights as Keeping Perspective: Julian Robertson’s Last Letter to Investors

Dividend Growth Portfolio 1st Quarter 2018 Letter to Investors

The first quarter of 2018 was not kind to value and income investors. Long-term bond yields started rising in the second half of last year, and that trend accelerated in January. For the quarter, the Dividend Growth portfolio lost 7.36% vs. a loss of 1.22% on the S&P 500. [Data as of 3/30/2018 as reported by Interactive Brokers. Past performance is not a guarantee of future results.]

Remember, as bond yields rise, bond prices fall, as do the prices of bond proxies such as utilities, REITs and other high-yielding stocks.

At the same time, the great “Trump Rally” that kicked off after the 2016 election reached a frenetic climax in December and January. The proverbial wall of worry that has characterized the “most hated bull market in history” since 2009 crumbled and was replaced by the fear of missing out, or “FOMO” in traderspeak.

The combination of a surge in bond yields and a sudden preference for high-risk/high-return speculation over slow-and-steady investment caused most income-focused sectors to underperform in January.

And then February happened. Volatility returned with a vengeance, dragging virtually everything down, growth and value alike. So, in effect, value and income sectors enjoyed none of the benefits of the January rally, yet still took a beating along with the broader market in February and March.

SectorBenchmarkQtr. Return
Large-Cap GrowthS&P 500 Growth1.58%
Large-Cap StocksS&P 500-1.22%
InternationalMSCI EAFE Index-2.19%
UtilitiesS&P 500 Utilities-3.30%
Large-Cap ValueS&P 500 Value-4.16%
Real Estate Investment TrustsS&P U.S. REIT Index-9.16%
Master Limited PartnershipsAlerian MLP Index-11.22

It’s striking to see the differences between sectors. Even after the selloff in the leading growth stocks — the “FAANGs” of Facebook, Amazon, Apple, Netflix and Google — the S&P 500 Growth Index still managed to finish the quarter with a 1.58% gain.

Meanwhile, the S&P 500 Value Index — which is a reasonable proxy for Sizemore Capital’s Dividend Growth Portfolio — was down 4.16%.

It actually gets worse from there. REITs and MLPs — two sectors in which Sizemore Capital had significant exposure at various times during the quarter — were down 9.16% and a staggering 11.22%, respectively.

Suffice it to say, if your mandate calls for investing in income-oriented sectors, 2018 has been a rough year.

I do, however, expect that to change. While I consider it very possible that we see a bona fide bear market this year, I expect investors to rotate out of the growth darlings that have led for years and into cheap, high-yielding value sectors that have been all but abandoned.

Why a Bear Market is a Real Possibility

They don’t ring a bell at the top. But often times, there are anecdotal clues that a market is topping.

As a case in point , my most conservative client — a gentleman so risk averse that even the possibility of a 10% peak-to-trough loss was anathema to him — informed me in January that he would be closing his accounts with me because I refused to aggressively buy tech stocks and Bitcoin on his behalf.

He wasn’t alone. Again, anecdotally, I noticed that several clients that had been extremely conservative since the 2009 bottom suddenly seemed to embrace risk in the second half of last year. The fear of missing out — FOMO — had its grip on them.

This is the first time I’ve seen FOMO in the wild since roughly 2006. I was working in Tampa at the time, and the Tampa Bay area happened to be one of the centers of the housing bubble. I recall watching a coworker buy a house she couldn’t quite afford because she was afraid that if she waited, prices would quickly get out of her reach. She and her husband bought the house as the market was topping, and it was a major financial setback for them.

It may be in bad taste to recount personal anecdotes like these, but I do for an important reason. I want to avoid falling into the same mental trap.

Today, the market is expensive by historical standards. The cyclically-adjusted price/earnings ratio — or CAPE — is sitting at levels first seen in the late stages of the 1990s tech bubble.

Meanwhile, we are now nearly a decade into an uninterrupted economic expansion, and we’re effectively fighting the Fed. Chairman Jerome Powell has made it very clear that he intends to raise interest rates fairly aggressively to nip any potential inflation in the bud.

None of this guarantees that the current stock correction will slide into a bear market. (The same basic conditions were true in the 1998 correction, and stocks went on to rally hard for another two years.)

But it does tell me that caution is warranted, and that now — more than ever — we should stick with financially-strong value and dividend stocks. In a turbulent market, I expect to see investors seek shelter in “boring” value stocks offering a consistent payout. In a market in which capital gains no longer appear to be the “sure thing” they were a year ago, a stable stream of dividend income is attractive.

Will Value Get Its Mojo Back?

Growth utterly destroyed value last quarter. But this is really just a continuation of the trend of the past five years.

Consider the five-year performance of the iShares S&P Value ETF (IVE) and the iShares S&P 500 Growth (IVW). Growth’s returns have literally doubled value’s, with most of the outperformance happening in 2017.

Growth massively outperformed value in the last five years of the 1990s. But this is by no means “normal” or something that should be expected to continue indefinitely. Consider the performance of the same two ETFs in the five years leading up to the 2008 meltdown.

Value stock returns didn’t quite  double their growth peers. But they outperformed by a solid 40%, and that’s not too shabby.

This by no means guarantees that value stocks will outperform or that the specific value stocks Sizemore Capital owns will outperform. But if the market regime really has shifted — and I believe that it has — then the “FAANGs” story is over. Investors will be searching for a new narrative, and I believe that value and income stocks will be a big part of that story.

In the first week of the second quarter, I moved to a moderately defensive posture, shifting about 20% of the portfolio to cash. This gives us plenty of dry powder to put to work once this correction or bear market runs its course. But if I’m wrong, and this is yet another buyable dip, then we still have substantial skin in the game.

And whether the market goes up, down or sideways, we’ll continue to collect a high and rising stream of dividend income.

Looking to a better second quarter,

Charles Lewis Sizemore, CFA

ETF Flow Portfolio 1st Quarter Letter to Investors

The ETF Flow Portfolio met its first real challenge in the first quarter of 2018, and I’m proud to say it passed with flying colors. The portfolio returned 2.99% for the quarter compared to a loss of 1.2% for the S&P 500. (Returns were net of trading costs but gross of management fees, which may vary by account size. As always, past performance no guarantee of future results.)

But what excites me the most isn’t the outperformance. It’s the fact that the outperformance was achieved by successfully side-stepping the major drawdowns in February and March. The S&P 500 was down 3.9% in February and 2.7% in March on a price basis. By comparison, ETF Flow was down 0.06% in February and up 0.46% in March.

By using its short-term momentum indicators, ETF Flow rotated into defensive positions and spent most of February and March in bonds and cash equivalents.

The stock market has arguably been the greatest wealth-creating machine in all of human history, and it allows passive investors to own a little piece of the world’s greatest companies. But that doesn’t mean that buying and holding an index fund is the best strategy at all times. Market valuations swing like slow-motion pendulums, gradually moving from underpriced to overpriced and back to underpriced again. Unfortunately, after nearly a decade of uninterrupted bull market, stock prices have swung towards being overvalued again. The cyclically-adjusted price/earnings ratio (“CAPE”), among other valuation metrics, suggests that stocks are priced to deliver flat or negative returns over the next decade.

At the same time, stocks investors are effectively fighting the Fed, as Chairman Jerome Powell is committed to gradually raising short-term rates and winding down the Fed’s balance sheet, which was inflated by years of quantitative easing.

Meanwhile, GDP growth and employment both look exceptionally strong at the moment, particularly compared to recent years. But these are lagging indicators that tend to be at their highest near the end of the economic cycle.

None of this is to say that expensive stocks can’t get more expensive or that the stock current correction is guaranteed to slide into a full-blown bear market. But it does suggest that it is prudent to maintain a nimbler trading strategy or, at the very least, to diversify into complementary, noncorrelated strategies. And this is precisely the role that ETF Flow successfully filled during this correction and the role that I expect it to fill going forward.

Looking forward to a strong 2018,

Charles Lewis Sizemore, CFA

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Finance Blogger Wisdom: What’s a Reasonable Estimate for Portfolio Returns Going Forward?

Tadas Viskanta, editor of the excellent finanical blog Abnormal Returns, asked a group of financial bloggers the following question:

Assume you are advising a pension fund, endowment or foundation. What is a reasonable long-term expectation for real returns for a well-diversified portfolio?

The answered varied, but it seems like the consensus was somewhere in the ballpark of 2%-3%, though some had estimates of 5% or better.

This was my response:

We all know the standard answer: stocks “always” return 7% to 10% per year. But while that might be true over a 20-30-year time horizon, the reality can be very different over shorter time horizons.

At today’s valuations, the S&P 500 is priced to actually lose 2%-3% per year over the next eight years. That estimate is based on historical CAPE valuations, which have limitations (including the failure to take into account differences in interest rates over time). So, let’s assume the CAPE is being unduly bearish given today’s yields and that stock returns end up being 5% better than the CAPE suggests. We’re still looking at returns of 2%-3%.

That’s roughly in line with with the yields you can achieve on a high-quality bond portfolio. So, core assets should return something in the ballpark of 2%-3% per year over the next 8-10 years. Overseas (and particularly emerging market) stocks might do significantly better than that, and commodities might enjoy a good decade starting at today’s prices. So, a diversified portfolio that included emerging-market stocks and commodities might post respectable returns. But a standard 60/40 portfolio is unlikely to return better than about 3% over the next 8-10 years.

There were some very solid, very thoughtful responses from several financial bloggers I respect and follow.  To read the other answers, see Finance blogger wisdom: real returns.

 

 

This article first appeared on Sizemore Insights as Finance Blogger Wisdom: What’s a Reasonable Estimate for Portfolio Returns Going Forward?

Emerging Markets Set to Take the Lead?

The following is an excerpt from Best ETFs for 2018: iShares Emerging Markets Dividend ETF Is Still in the Race.

If there is a dominant theme in the Best ETFs for 2018 contest, it would seem to be “Go America!” and specifically “Go American tech!”

The Market Vectors Semiconductor ETF (SMH) is leading the pack, up 7%, and four of the top five places are all held by ETFs specializing in tech or biotech.

But we still have a long way to go in 2018, and tech is starting to show signs of breaking down as we finish out the quarter. I expect my pick – the iShares Emerging Markets Dividend ETF (DVYE) to ultimately take the crown.

The U.S. market has been the undisputed winner of the post-2008 bull market. Since March 2009, the SPDR S&P 500 ETF (SPY) is up about 240%. The iShares MSCI EAFE ETF (EFA) and the iShares MSCI Emerging Markets ETF (EEM) — popular proxies for developed foreign markets and emerging markets, respectively — are up 111% and 142% over the same period.

But with that outperformance has come major overvaluation. The U.S. market is the most expensive major market in world based on the cyclically adjusted price/earnings ratio, or “CAPE” (only tiny Denmark and Ireland are more expensive). The U.S. market trades at a CAPE of 31 … which is the level it reached in late 1997, in the midst of the dot com bubble.

Meanwhile, emerging markets are downright cheap. As a sector, emerging markets trade at a CAPE of less than 18, and many individual countries are even cheaper. Brazil trades at a CAPE of 14, and Russia 7.

To continue reading, please see Best ETFs for 2018: iShares Emerging Markets Dividend ETF Is Still in the Race.

This article first appeared on Sizemore Insights as Emerging Markets Set to Take the Lead?

Someone Fat Finger an MLP Trade?

Interesting price action in MLPs today. Some Twitter banter:

ETE and EPD both ended down on the day, along with most of the rest of the market. But it was a wild ride!

This article first appeared on Sizemore Insights as Someone Fat Finger an MLP Trade?

Are the FANGs Holding Up a Weak Market?

Data as of 3/26/2018. Past performance no guarantee of future results.

It remains to be seen whether the market is in the midst of a garden-variety 10% correction or if this is the start of a deeper bear market. But it does seem like this market is being held aloft buy a small handful of large-cap tech stocks: the infamous FAANGs.

Let’s play with the numbers a little.

The S&P 500 cratered in early February but quickly rebounded, recouping about two thirds of its loss. And when the market rolled over again this month on trade fears, it stopped short of hitting new lows.

Data as of 3/26/2018. Past performance no guarantee of future results.

But stripping out tech and telecom stocks, we see a different picture. the S&P ex-Technology and Telecom Services Index fell in lockstep with the S&P 500, but the recovery was less robust. It recovered a little over half the prior losses. And when stocks dropped again in March, the ex-Tech and Telco fell to new lows.

Data as of 3/26/2018. Past performance no guarantee of future results.

Now, let me be clear that this is by NO means a thorough analysis. This is a superficial first scan, and I plan to dig deeper this week.

Furthermore, the data as presented here doesn’t specifically isolate the impact of the FAANGs. The S&P 500 ex-Technology and Telecom Services index actually includes one of the FAANGs — high flier Amazon.com (AMZN) — which makes its performance look better than it should. It also excludes stodgy old telecoms like AT&T (T) and Verizon (VZ), both of which have gotten obliterated this year as interest rates have risen… and which didn’t participate at all in the rally earlier this month. Excluding telco also makes the ex-tech index look better than it should.

I’ll dig deeper into the data later to build a true S&P 500 ex-FAANGs index, but this initial look would suggest that the this market is indeed narrow, being held aloft by Big Tech. That’s worrisome… and it makes me believe that more pain could be coming.

Disclosures: No positions in the stocks mentioned.

This article first appeared on Sizemore Insights as Are the FANGs Holding Up a Weak Market?

Review: Skin in the Game

It’s morally wrong to enjoy the benefits of something while leaving others to accept all the risks.

This is the central theme of Nassim Nicholas Taleb’s latest work, Skin in the Game: Hidden Asymmetries in Daily Life, a book that should be required reading for anyone in public office or in any position of authority or influence. And by “position of authority or influence,” I’m not speaking only of politicians or journalists. I would include everyone from the town doctor to the b-list celebrity with a large Twitter following.

The concept of skin in the game can be best understood by what Taleb calls the “Silver Rule,” or the flip side of the Golden Rule to do unto others as you would have them do unto you: Don’t do onto others what you wouldn’t want them to do to you. Don’t expose others to harm unless you are also directly or indirectly exposed.

As an example of what that looks like in the real world, consider ObamaCare. Our leaders passed legislation that caused a massive spike in the cost of health insurance — doing real harm to tens of millions of Americans — while accepting none of the risk. Congressmen don’t buy their health insurance on an ObamaCare exchange and are given — at taxpayer expense — vastly superior health plans.

Or, as Taleb has pointed out in the past, consider the Iraq War and the various Western interventionisms in the Arab world. Our leaders might have been less interested in regime change if, like the kings of ancient times, they had to lead the army from the front.

Skin is less structured and less technical than Taleb’s previous books and will be far easier to digest for a non-financial reader. It feels less like a book and more like a long, animated chat with Mr. Taleb in a cafe over several strong cups of coffee.

I  thoroughly enjoyed Skin in the Game and that I strongly recommend it. But if you are new to Taleb’s work, you shouldn’t start with this book. It will make more sense and you’ll get more out of it if you’re already familiar with Taleb’s core ideas: the role of randomness in life, naive empiricism, black swans (low-probability but high-impact events), fragility vs. antifragility, etc.)

I recommend you start by reading his first book, Fooled by Randomness, particularly if you have a background in finance or trading. I first read it in 2002, and there are precious few books that have had more of an influence on me.

But if you are familiar with Taleb and generally like his work, you’ll find Skin in the Game to be a worthwhile addition to your library. It has that peculiar cocktail of  logical reasoning, historical perspective, statistical rigor and good old-fashioned street smarts that Taleb is known to mix.

Before I sign off, I’d like to end with a quote of Taleb’s that made me smile… because it is something that I myself have done. If you’re going to start a business, you should put your name on the door. As Taleb puts it, “products or companies that bear the owner’s name convey very valuable messages. They are shouting they have something to lose. Eponymy indicates both a commitment to the company and a confidence in the product.”

I couldn’t agree more.

Kudos to Mr. Taleb on another solid work, and I look forward to the next one.

See also:

The Bed of Procrustes

Antifragile

This article first appeared on Sizemore Insights as Review: Skin in the Game

Oddball Dividend Stocks With Big Yields

 

Copyright Wintertwined

The following is an excerpt from 5 “Oddball” Dividend Stocks With Big Yields, originally published on Kiplinger’s.

It’s not the easiest market out there for income investors. With bond yields being depressed for so many years (and still extremely low by any historical standard) investors have scoured the globe for yield, which has pushed the yields on many traditional income investments – namely, bonds and dividend stocks – to levels far too low to be taken seriously.

Even after rising over the past several months, the yield on the 10-year Treasury is still only 2.9%, and the 30-year Treasury yields all of 3.2%. (Don’t spend that all in one place!) The utility sector, which many investors have been using as a bond substitute, yields only 3.4%. Yields on real estate investment trusts (REITs) are almost competitive at 4.4%, but only when you consider the low-yield competition.

Bond yields have been rising since September, due in part to expectations of greater economic growth and the inflation that generally comes with it. This has put pressure on all income-focused stocks. This little yield spike might not be over just yet, either – especially if inflation creeps higher this year.

Even if bond yields top out today and start to drift lower rather than higher, yields just aren’t high enough in most traditional income sectors to be worthwhile. So today, we’re going to cast the net a little wider. We’re going to take a look at five quirky dividend stocks that are a little out of the mainstream. Our goal is to secure high yields while also allowing for fast enough dividend growth to stay in front of inflation.

The GEO Group

Few companies are as quirky – or have quite the pariah status – as The GEO Group (GEO). GEO is a private operator of prisons that is organized as a real estate investment trust, or REIT.

Yes, it’s a prison REIT.

Prison overcrowding has been a problem for years. It seems that while getting tough on crime is popular with voters, paying the bill to build expensive new prisons is not.

This is about as far from a feel-good stock as you can get. It ranks alongside tobacco stocks on the scale of political incorrectness. The sheer ugliness of its business partially explains why it sports such a high dividend yield at well above 8%.

It’s also worth noting that this stock is riskier than everything else on this list. The U.S. is slowly moving in the direction of legalization of soft drugs like marijuana. While full legalization at the federal level isn’t yet on the horizon, you have to consider that a significant potential risk to GEO’s business model. Roughly half of all prisoners in federal prisons are there on drug-related convictions. At the state level, that number is about 16%.

GEO likely would survive drug legalization, as the privatization of public services is part of a bigger trend for cash-strapped governments. But it would definitely slow the REIT’s growth and it would seriously raise questions of dividend sustainability.

Furthermore, prison properties have very little resale value. You can turn an old warehouse into a trendy urban apartment building. But a prison? That’s a tougher sell.

So again, GEO is a riskier pick. But with a yield of more than 8%, you’re at least getting paid well to accept that risk.

To read the rest of the article, please see  5 “Oddball” Dividend Stocks With Big Yields,

This article first appeared on Sizemore Insights as Oddball Dividend Stocks With Big Yields

Revisiting Warren Buffett’s Bet on the S&P 500

Copyright DonkeyHotey

The Oracle of Omaha made a very public bet with Protégé Partners on December 19, 2007 that over the following 10 years, an unmanaged S&P 500 index fund would outperform a collection of five high-profile fund-of-funds.

Buffett won the bet… and it wasn’t even close. The S&P 500 returned a cumulative 125.8% (or 8.5% per year). The hedge funds delivered cumulative returns ranging from just 2.8% to 87.7% (0.3% to 6.5% per year). And remember, this time period includes the 2008 meltdown.

As Buffett writes in his latest annual letter,

The five funds-of-funds got off to a fast start, each beating the index fund in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund.

Let me emphasize that there was nothing aberrational about stock-market behavior over the ten-year stretch. If a poll of investment “experts” had been asked late in 2007 for a forecast of long-term common-stock returns, their guesses would have likely averaged close to the 8.5% actually delivered by the S&P 500. Making money in that environment should have been easy. Indeed, Wall Street “helpers” earned staggering sums. While this group prospered, however, many of their investors experienced a lost decade.

Performance comes, performance goes. Fees never falter.

On this count, I can’t argue with the Oracle. One fund delivered annualized returns of 6.5%, which might be considered competitive with the 8.5% annualized return of the S&P 500 on a risk-adjusted basis. I say “might” because I don’t have enough information to say definitively either way. But I can say with confidence that the performance of four out of the five fund of funds was pathetic.

Investors paid a lot of money in fees and got virtually nothing in return.

I’m not, however, willing to throw out the baby with the bath water and eschew all hedge funds. Depending on your time horizon and objectives, certain funds and certain strategies put into practice by funds might be worth a place in your portfolio. Over the past decade, I’ve placed many of my accredited investor clients in a variety of absolute-return funds invested in everything from medical accounts receivables to option-writing strategies. And the funds did exactly what I wanted them to do: They reduced portfolio volatility without sacrificing much in the way of returns. They avoided major drawdowns. And importantly, they gave my clients the piece of mind they needed.

I can’t, in good faith, invest 100% of the portfolio of a retirement-aged client in an S&P 500 index fund. That would be irresponsible on a level that should be considered criminal. But I also can’t, in good faith, invest a significant portion of their portfolio in bonds at today’s yields. Alternative investments, which would include hedge funds, can — if done right — act as a substitute for traditional bonds.

But the key here is “done right.” When evaluating a hedge fund, I ask myself the following questions:

  1. Does the hedge fund actually hedge, in that they manage risk? Or is “hedge fund” merely code for “aggressive equity trading.” Most of the high-profile managers you see on TV (Bill Ackman, Carl Icahn, etc.) fall into the latter category. I have no interest in those kinds of managers.
  2. How large is the fund? There is a sweet spot here. Ideally, you like to see at least $100 million under management. You know that the manager can keep the lights on with the fees generated from a portfolio that size. But when a fund gets to be several billion dollars, it can be too big to operate in their area of expertise. Just about any strategy becomes unmanageable at a large enough asset size. Buffett himself has complained that he can’t invest the way he wants to at Berkshire Hathaway because it’s simply too big at its current size.
  3. Is their strategy — and any hedges they have in place — going to survive a period of significant market turmoil? You generally can’t know with 100% certainty, but it’s useful to know how the fund performed in past periods of volatility, such as the 2008 meltdown or the 2010 or 2015 flash crashes. Or for that matter, the recent spate of volatility we saw in February.
  4. Is the fund illiquid? And if so, why? If the fund invests in traded stocks or options, it should offer monthly or at least quarterly liquidity. There’s just no reason why it wouldn’t. But if the fund invests in illiquid notes or real estate, then a lockup might be 100% warranted.
  5. Is the fund minimally correlated to the stock market… and to the other alternatives in my portfolio? This is an important one. There is literally no point in investing in an alternative strategy if it’s just going to follow the rest of your portfolio lower in a bear market.

Buffett is right that most hedge fund managers don’t earn their fees. But I’ll never begrudge a manager for charging a high fee if they’re delivering something I can’t get elsewhere for cheaper.

 

This article first appeared on Sizemore Insights as Revisiting Warren Buffett’s Bet on the S&P 500