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Does Warren Buffett Not Understand Risk-Adjusted Returns?

Jared Dillian is the editor and publisher of the Daily Dirtnap and is the author of "Street Freak" and "All the Evil of This World."
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In his latest investor letter, Warren Buffett says everyone should be in low-cost S&P 500 index funds -- except for Warren Buffett, of course.

Buffett has handily outperformed the benchmark, with Berkshire Hathaway shares gaining 20.8 percent annually on average since 1965, compared with 9.7 percent for the S&P 500. If you thought this performance was repeatable, you would just give your money to Warren Buffett instead of Vanguard.

But Buffett doesn’t invest in a slice of the S&P 500. He has a very concentrated portfolio. How does he pick the right stocks? Is he some kind of sorcerer? No doubt he’s a great investor, but he also has the advantages of scale, and he can do things normal investors can't, such as provide quasi-bailout financing to Goldman Sachs Group Inc. and Bank of America Corp., which pay humongous preferred dividends. When you get large enough to attain lender-of-last-resort status, benefits accrue.

So, if you really believe in index funds, then why build a firm around trying to beat an index fund? The answer is that you only do that if you believe an index fund really can be beaten. Here's Buffett in his investor letter released Feb. 25 and still being hotly debated on Wall Street:

There are, of course, some skilled individuals who are highly likely to outperform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat.

The Efficient Market Hypothesis doesn’t say nobody can beat the market except for 10 people. It says nobody, absolutely nobody, over time can beat the market on a repeatable basis. But saying you can’t beat the market is a lot different than saying you probably can’t beat the market. You probably can’t beat the market will motivate a lot of people to try. It is like that softball-in-the-basket game at the county fair: you know it can be done, but the darn ball just keeps bouncing out.

Which brings us to hedge funds. Buffett seems to enjoy beating up the industry, and if he were right that hedge funds don’t add any value after fees, then why doesn’t the industry just shrivel up and blow away? Are rich people dumb?

I’m guessing that rich people are not dumb, and that there are reasons to invest in hedge funds other than just beating the market. First, it's important to realize that when you invest in an index fund, you get not just the return of the index, but the volatility of the index. Professional money management doesn’t necessarily offer better absolute returns, but what it should offer is better risk-adjusted returns.

Below are the returns of the funds of hedge funds that form the basis of a bet Buffett made that a basket of hedge funds would fail to keep pace with an S&P 500 Index fund. The first thing that becomes obvious when looking at the table is that three of the funds of funds did very poorly. If you are generated annualized returns of about 1 percent in the midst of a big bull market, then you've failed.

Fund of funds B did marginally better and fund of funds C did quite a bit better -- even though it didn't beat the index. But all five of these investments beat the S&P 500 in one respect: they offered lower volatility than the index. And if you calculate their Sharpe ratios and compare them with the S&P 500, fund C is actually superior to the index. If I were a shareholder of fund C, I would be pretty happy in spite of the underperformance, because I received a better return per unit of risk. In terms of professional money management, that is what you pay for. That is success.

You will also notice that the S&P 500 Index fund has the largest drawdown of all the funds, which is important in terms of psychology. Holding onto an investment in good times and bad sounds easy, but not everyone has that sort of constitution. When you log into Vanguard's website and see your number getting smaller every day until it's eventually cut in half -- like during the financial crisis -- you do what every other emotional person would do, which is you take action to conserve capital at perhaps the worst possible time.

The best way to get rich is to do it slowly, by letting something compound. But if you are too chicken to let it compound in stressful times, then it's best to invest in something without a lot of volatility like a hedge fund product.

Berkshire Hathaway is simply a sine wave with a bigger amplitude. It has higher returns but with more volatility over the same time period as the hedge fund bet. Somewhere, a hedge fund manager is getting the return of a high yield bond with the volatility of a certificate of deposit. That is the guy who is a sorcerer.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Jared Dillian at j.dillian@bloomberg.net

To contact the editor responsible for this story:
Robert Burgess at bburgess@bloomberg.net