A month ago Fortune published an article about a hedge fund of funds group that made a bet with Warren Buffett that it could pick a group of hedge funds that would outperform the S&P over the next ten years. I remember in particular the last line of the article, in which Ted Seides, one of the bettors, said the following:
"Fortunately for us, we're betting against the S&P's performance, not Buffett's."
Wait a minute, say I. That statement might be true in terms of the specific bet, but it's certainly not true in real life. As I see it, every money manager who accepts outside investors' money, especially those who call themselves value investors, is essentially "betting" that he can beat the performance of Berkshire Hathaway. Imagine the following scenario: You're interviewing a potential hedge fund manager and he says the following:
1) "I'm a value investor. All my life I've idolized Warren Buffett. I go to Omaha every year. He inspired me to start my own hedge fund. I own Berkshire shares myself."
2) "I will charge you 2% of assets and 20% of profits for the benefit of my investment prowess, which is a combination of my own ability and the principles I've learned from my idol, Warren Buffett."
So far so good. Some variation of the above can be heard all the time in Midtown Manhattan conference rooms. Now it's your turn. You should say the following in reply:
3) Your idol, Warren Buffett, is still alive and still working hard.
4) I can become partners with Buffett today, simply by buying a share of Berkshire Hathaway. If I did that I'd get the benefit of his ability and his principles firsthand, cutting out the middleman as it were.
5) Berkshire's stock price, $111,770 as we speak, certainly does not seem overvalued, and may in fact be significantly undervalued.
6) It does not cost 2 and 20 to become Buffett's partner. It costs maybe $10 to buy one A share, plus my share of Buffett's $100,000 salary: about 6.5 cents per A share per year.
7) Berkshire Hathaway is rated AAA and it's a "real" AAA. Chances are your hedge fund holds positions in sub-AAA names, so on a look-through basis it's less than AAA. Chances are it also borrows money on such terms that would make it less than AAA.
8) Given all this, doesn't it make more sense for me to buy Berkshire than to invest in your hedge fund?
If your potential money manager answers this question by saying "Fortunately, we're not betting against Buffett's performance," you should then say "You may not be, but I certainly am, relatively speaking, if I invest with you instead of him."
My point is this: Your money manager should be able to articulate why he expects the high-cost investment option--his hedge fund--to outperform the readily available low-cost option. I'm not saying it's impossible to beat Berkshire, but your money manager should have the integrity to concede that that should be his goal, and you are entitled to know how he expects to do it.