Home Daily Blitz Warren Buffett: Why Hedge Funds Fail
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Warren Buffett: Why Hedge Funds Fail

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marketwatch articleThe following is an excerpt from Mitch Tuchman | October 17, 2015 | MarketWatch.com |

You might be surprised to see occasional headlines bemoaning the poor performance of hedge funds versus the market indexes. Not Warren Buffett.

Hedge fund managers serve two masters: their clients and themselves. That sounds like a solid alignment of interests, but it's not, the billionaire investor says. That's because hedge fund chiefs get paid win or lose.

The fixed annual fees hedge funds charge are the real money-makers, not the contractual "bonuses" for performance. By extension, Buffett is making a statement about active managers of all kinds. They're not in the business of beating the market. They're in the business of attracting assets and that's all.

For example, a hedge fund managing $1 billion charges a fee of 2% of those assets per year plus 20% of trading profits.

Let's assume the fund breaks even — no profits. That's still $20 million in fees. When a hedge fund controls $20 billion, the income is $400 million.

Getting big

Because of the fixed 2% fee, there's less and less reason to worry about collecting the 20% of profits, Buffett notes. Rather, the funds reward themselves just for getting big. "[You] don't have to particularly deliver. [The] promise lasts long enough to get you and your children rich," Buffett explained.

It's not surprising then that most hedge funds last about five years, and that one in three fails on an annual basis. Why not go into the hedge fund business? The worst that could happen is that you close up shop and move on, millions of dollars richer. The best outcome would be billions of dollars instead.

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