Are You With Buffett or With the Hedge Funds?

If you like high stakes poker, you'll like this.

Back in 2008 (great timing!), Buffett made a $1 million performance bet with Protégé Partners LLC, a fund of hedge funds.  Buffett took the Vanguard S&P 500 Index fund and Protégé chose 5 funds comprised of hedge funds to see which would have the best performance over 10 years.  At the half-way point, Buffett is up +8.69%, Protégé's picks are up + 0.13%.

Worth emphasizing and keeping in mind:

• the difference (not unexpectedly) seems to be in the costs.  As most observers know, hedge funds have notoriously high fees, typically north of 2%, along with a percentage of profits.  This contest is turning out to be a real-life demonstration that even brilliant strategists have difficulty overcoming those kinds of costs over the long run. 
• Secondly, although I can't say I am familiar with Protégé, I believe I can safely assert that they are considerably better positioned to pick fund managers than, say, the typical advisory firm for individuals purporting to be able to select superior active mutual fund managers. 
• Thirdly, an investor building a nest egg would face a difficult decision at this point even though the experiment is only half way over - can he or she take another 5 years of similar results? 
• Finally, if Buffett had a portion invested in a bond index fund over this difficult period, his returns would be considerably higher than +8.69%.  In fact, the zero coupon bond each participant put the payout funds in increased in value so much that they already have the $1 million to be paid out!  The charity receiving the loser's funds will likely get considerably more than $1 million.  This speaks to the value of sticking with an allocation.

What is the bottom line?  Low-cost index funds are not easy to beat.  Maybe the market isn't efficient, but it sure acts like it is!

CNBC SCARE MONGERING

On another topic, I have to say that I've immensely enjoyed watching CNBC over the past few months. On a daily basis, they have tried their hardest to convince viewers that apocalypse was around the corner whether it was an apoplectic Simon Hobbs or a ranting Rick Santelli.  They paraded on  politicians who exhibited their talents for playing up the fiscal cliff and avoiding specifically answering questions.

Viewers were poised for a huge air pocket over the last weeks of 2012.

Obviously it didn't happen.  The question is why?  I have to offer one theory I haven't seen bandied about.  Markets emphasize recent experience and put great weight on mistakes.  Indeed, 2008 is a recent example that has kept many would-be investors on the sidelines.  Even more recently, however, many investors sold out in 2011 in the midst of the hoopla surrounding the debt ceiling talks and missed the strong rally at the end of that year.  This time around they made up their minds they wouldn't be spooked.  The widely-anticipated down draft failed to materialize.  Investors held on to a greater degree as the fiscal cliff approached at the beginning of 2013.  As this happens, it seems a sort of immunity builds up.  Keep saying there is a boogey man behind the bush and eventually it loses its scare factor - especially when believing it costs money and performance rankings.

CNBC and the Fed Meeting

I've got two questions:  First, do the commentators on CNBC have any idea how clownish they look?  Yesterday, as the market rose, then plummeted on the Fed announcement and finally ended up sharply, the commentators, guests, as well as the regular reporters, had great after-the-fact explanations at each stage-as they do at the end of each day. They parade on - one right after the other - first explaining that the Fed didn't tell markets what they wanted to hear as prices went down and then oops! prices are rising; so guests and reporters reparsed the Fed statement and found that  the Fed said exactly what the market  wanted to hear.

Secondly, do the reporters realize how ridiculous they look in practically begging Bernanke to take actions to push stock prices higher?  The incessant pleading in the hope that he will announce that rates will stay low for a protracted period, that he will announce QE 3, that he will change the maturity distribution of the Fed's Treasury portfolio, that the committee will lower the rate on excess reserves, etc. repeated over and over is akin to beggars on the streets of London asking for crumbs from the passersby.  Sadly, this has turned into the step child of the deficit crisis.

Since 1994, when Greenspan actually surprised Wall Street with a rate increase, the likes of Goldman Sachs, Bank of America, and the late Lehman Brothers have fattened themselves on the free ride given by the Fed in announcing its policy and spelling out its intentions.  By announcing its policy and now actually holding periodic press conferences, in case CNBC et. al, are too stupid to understand it, they have enabled the Street to exploit carry trades in which they sweep in essentially risk-free profits by borrowing practically free money and lending further out the yield curve at higher rates.  The bottom line, sadly, is that  the Federal Reserve by its actions (in the guise of transparency)  has become totally impotent - a lackey for the banking system.  Short-term rates have been close to zero and two massive attempts at monetizing the debt (let's call it what it really is), and still we are scratching our heads and wondering if we're facing a "double dip."

As for CNBC - at least it's great entertainment.

Is it time to capitulate?

I don't know if anyone's tried to rank the words investors least like to hear, but contagion and capitulation have to be, I would think, somewhere near the top of the list. Both were bandied about on Friday. Capitulation because of the big down draft in stock prices and contagion because of Hungary's debt woes.

I spent a good part of the day Friday glued to the TV set watching the hysteria build on CNBC. By the time Maria Bartiromo came on, it was at a fever pitch. She ramped it up a notch as she's wont to do by screeching that it's the President's fault because he had promised the market a good employment report at his press conference earlier in the week. Huh? She said the President had said he would keep his boot to the throat of BP. Huh? I watched that press conference; and as I recall, a reporter had asked the question in those terms and the President had said he wouldn't phrase it like that. Apparently, hysteria on CNBC knows no bounds. Look up Rick Santelli in the dictionary if you're not convinced.

According to Ms. Bartiromo, the President had gotten investor's expectations up and apparently was responsible for the disappointment experienced when the numbers were released. All I've got to say is that investors moving in and out of the market on the basis of one economic report deserve what they get - good or bad. It isn't investing, it's speculating. Unfortunately, most viewers probably don't know the difference between the two and are getting whipsawed by Ms. Bartiromo, Mr. Santelli and their ilk.

All of this provides a teaching moment. In calm times, it is not as easy to get people's attention. Investors, as opposed to speculators, do a lot of work on their asset allocation and arrive at an allocation appropriate to their goals, risk tolerance, capacity to take risk etc. Investors recognize that there will be periods like now. Investors understand that a key is to not let emotions rule their investment decisions.

Investors recognize that the current market environment means different things to different people. Younger investors should have their buying hat on. This is why they hold bonds. At this point they should be thinking of incrementally reducing bonds and adding to stocks. Older investors, who have more assets than they need and plan on leaving a sizeable inheritance, should be of a similar mindset. For those tossing and turning at night and generally afraid to look at their account, you may want to think about putting 5 or 10% into bonds (actually bonds have done great in this market).

The point is to concentrate on making rational, non-emotional decisions. Waking up at 3 am and going on line to sell everything you own typically backfires.

On the contagion issue, it is possible to hyperventilate imagining the whole world defaulting. Recall that this first became an issue in 1997 with the East Asia crisis. Contagion in that episode eventually spread to South America. The important point is that it was contained and followed by strong markets.

Disclosure: This is not investment advice to any specific individual but is the opinion of the writer and is intended only for instructional purposes. Investors (and speculators) should do their own research and consult with an investment advisor before making investment decisions.