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ABOUT THIS EPISODE

This coming weekend is the annual Berkshire Hathaway shareholder meeting in Omaha. That means this week is the perfect opportunity to discuss a topic which will likely figure prominently at Berkshire this weekend: Ted Seides’s famous bet with Buffett. Ted and I discuss the origins of the bet, the nuances beneath the headlines, and whether he’d make the bet again for the next ten years. Along the way, we cover many hot topics like hedge funds, alternatives, fees, and indexing. Please enjoy!

For comprehensive show notes on this episode go to http://investorfieldguide.com/bet

For more episodes go to InvestorFieldGuide.com/podcast.

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Follow Patrick on Twitter at @patrick_oshag

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00:00:00This podcast is sponsored by cf institute the global association of investment professionals whose mission is to lead the investment profession by promoting the highest standards of ethics education and professional excellence for the ultimate benefit of society Cfo institute serves a global community of investment professionals working to build
00:00:17an investment industry where investors interests come first financial markets function at their best and economies grow The chartered financial analyst credential is the most respected and recognized investment management designation in the world The views expressed in this podcast do not necessarily represent the views of the faa institute
00:00:36Hello and welcome everyone I'm patrick o'shaughnessy and this is invest like the best this show is an open ended exploration of markets ideas methods stories and of strategies that will help you better invest both your time and your money You can learn mohr and stay up to date
00:00:53an investor field guide Dot com Patrick o'shaughnessy is a principle in portfolio manager at o'shaughnessy asset management all the pains expressed by patrick and podcast guests are solely their own opinions and did not reflect the opinion of o'shaughnessy asset management This podcast is for informational purposes only and
00:01:12should not be relied upon as a basis for investment decisions Clients of a saucy asset management may maintain positions in the securities discussed on this podcast thiss weekend i'll be making my first trip to the berkshire hathaway annual shareholder meeting with a group of friends It is therefore
00:01:27a great time to release this discussion with ted side he's on the famous bet he made with warren buffet which will no doubt be a key theme for the weekend's events We discussed the origin of the bet what it says about hedge funds in both the past and
00:01:40looking to the future and what investors should consider when building their portfolios today Stay tuned at the end of the conversation for a fun bonus question If you're interested in asset allocation hedge funds alternatives or fees you'll find a lot to learn in this episode you confined show
00:01:56notes at investor field guide dot com forward slash bet now please enjoy my conversation with my friend ted side he's on his bet with warren buffett So ted we're going to talk a lot about your famous or infamous bet with warren buffett today but i thought a fun
00:02:14place to start would be and you don't know this questions coming for you to describe your first trip to a berkshire hathaway shareholders meeting yeah the first time i went i was an equity research analyst at a hedge fund in the year two thousand and i remember well
00:02:33because well first of all it wasn't at the big palatial auditorium are conveyed quest center i think it's called where they have it today it was a much smaller might have even been a church i'm not sure if that's right but it's a much smaller venue i remember
00:02:49getting there and looking around and seeing packs of top hedge fund managers i knew in the world certainly didn't know who they were and there was a lot more they've circled back this it was a lot about the company and really great investment lessons i didn't go after
00:03:08that for a number of years actually probably until around the time of the bet and the first time i went after the bet it was much more of a cartoon show and i think in the last couple years it circled back to kind of a balance between really
00:03:18fun entertainment and substance about the company so so you and i are going i'm going for the first time and that's next week i've never been and so given that we're going to be there together with a couple other mutual friends what do you most excited for so
00:03:32now that it's changed so much and i see these pictures this massive auditorium of people it's like a like a destination of pilgrimage of sorts so so what should i have you most excited for Well almost excited to see it through your eyes i had no idea is
00:03:44your first trip and there are some other folks i know i can't i'm not liver you say who but i think people will will find out who are going for the first time and it's just it's such a unique experience now i will say i've probably gone ten
00:03:59times now and what i enjoy about it is spending time with so many friends that go out there so it's a cz much about the weekend for me now as it is just the event but it's one of the greatest unexpected comedy shows you'll ever see it seems
00:04:17almost like so into notre dame and and what's great about a school that has some sort of great athletic program is it's a reason to see all your friends every year every goes back for a game and it seems like this is like that for value investors so
00:04:29for you know kind of buy and hold investors yeah it's hard to describe the one thing i'll say i don't know what next next saturday i guess i don't know what it'll be like but it's usually the first beautiful day of the year that's great so there's a
00:04:39degree to which you're sitting there going wow it is gorgeous and sunny in omaha and we are sitting in this huge auditorium eating hot dogs and listening to them speak good good excuse for us to talk about your famous bat with buffet and we'll start right at the
00:04:53beginning which is for you to describe how the bet came about sort of the sea the seed stage of this behind the scenes before everyone became aware of this proffer me it goes back teo even to business school and i remember how one of the early episodes of
00:05:07my podcast with andre peril that was sitting in his class and he taught a case about warren buffett and and i certainly knew who warren was from my time at yale but what andre had emphasized was this was nineteen ninety nine so it was just around the time
00:05:22where people more publicly were starting to recognize who warned wass and he really was masterful in everything he says he's one of these people that just uses wisdom with everything he says so andre had said something about you should pay attention to how he manages his brand as
00:05:39well as how brilliant it is investing so i had that with me and then i guess it was two thousand five if he wrote about it in the letter when he wrote aboutthe had rocks and the got rocks or the got rocks and had rocks this whole notion
00:05:52of fees and financial services and about a year after that i saw a transcript of one of his sessions with students and a student had sort of interpreted that maybe he had said something i think he had said something in that annual meeting that you know a group
00:06:07of five hedge funds couldn't beat the market and a student had asked him about it and in this transcript he said well no one took me up on it so i must've been right and it was this was the summer of two thousand seven and at the time
00:06:21some prime had just started melting down hedge funds were doing great and i just thought you know that's just a little tea so i wrote him a letter like you have figured right an old fashioned guy an old fashioned letter i'd never met him before i made the
00:06:35letter i think cute see enough that i thought he would respond and i had heard that he was just legendary and how he responds toe communications and that certainly was a case and so i got a chicken scratch note back and that started a back and forth kind
00:06:50of letter communications which i still have some public but it's really entertaining and one thing led to another and after a while we sort of hacked out the terms of this of this bet so having seen the letters myself have been lucky to to read some of them
00:07:06it's fascinating the kind of negotiation on the back and forth of how the thing's actually going to be set up so maybe you could describe how the bet was kind of basically structured and funded so it started i didn't know exactly what he had said so i wrote
00:07:21him a letter that said i heard you suggested this and by the way i'll make it worth your while making fund of funds instead of hedge funds and their whole bunch of reasons why that was case and i picked five and then he said no it has to
00:07:33be ten and i said well i don't even know if i know ten fund of funds even though i was in the business so i sent him something back and then we went back and forth and so because of who he is and he certainly didn't know me
00:07:46he couldn't just go public with something and not know who the counterparty was so the first notion was that it had to be collateralized and that was fine and that started we'll talk about this but that started a discussion about volatility because i immediately said well if we're
00:08:00clad arising hedge funds and your collateralize ing berkshire stock ones more volatile than the other so you need to post more collateral than we do so there was all kinds of things that were involved in it and eventually he wanted to bet more than i was comfortable betting
00:08:14which was fine i ended up talking to my partners and that was how it became protege making the bet and then we sort of decided to make the bed and about a month or two later his attorney found this organization long bets which is a nonprofit that allows
00:08:29people to fund its long term wagers because it's it's difficult to make a bet legally even for charity and so they found that organization then it turned out the organization had some kind of commission structure and they certainly weren't used to bets of this size so we had
00:08:44to negotiate with the organization so that they had to fix tea and you know eventually it came to foshan but i will say that i've joked with warren about this he has bought companies on a contract on a single sheet of paper and yet this kind of handshake
00:08:57charitable wager ultimate was like a twenty five page legal contract so we can't get into which which the five fund of funds that were part of the bed and that was kind of part of the original agreement was that you wouldn't you would never disclose what they were
00:09:09but the you'd sort of track this year to year and you mentioned pr and this is one of the most interesting subplots of this whole thing is the potential for pr good and bad on both sides of the bet and i think that the simple easy headline is
00:09:25you know the s and p five hundred beat hedge funds the reason for that the easy reason to say that happened was because hedge funds charge these usurious fees he's massively high fees and that's kind of it so case closed you know should buy go to vanguard instead
00:09:40of ever caring about hedge funds again we're going to spend a lot of the rest of this conversation unpacking that kind of silly headline but before we do that talk about the pr angle as you saw it playing out so the bet you said was two thousand seven
00:09:55so hedge funds had an early lead so talk about how pr was handled both on your side from your perspective if you even cared andi also kind of how you saw it on being handled by him on his side i want to come back to whether or not
00:10:08what he's saying is silly because i don't agree with you that it's just silly so that's pretty important but the pr side is just fascinating so when we made the bet i originally wanted it to be anonymous I didn't care my partner's got involved before said well let's
00:10:23just make it protege this is only gonna be good for us to be associate with warren and that made a lot of sense so we did that and warren adamantly wanted teo as an admit warren had suggested that he would disclose the results of his annual meeting and
00:10:35that would be fun and i had sort of pushed back and said well the horse race component to this is kind of exactly what is wrong with asset management what about we only talk about the bet if the snp drops more than ten percent over a period of
00:10:49time and i'll just trust that you can figure out how to handle that he didn't really want to do that so that was that was the arrangement and the bet started in january one two thousand eight so so the year of the crisis it was announced sort of
00:11:05formally in this wonderful article that carol loomis wrote in june of two thousand eight and so now we're in two thousand nine and in two thousand eight the market that something was down thirty seven percent the hedge funds after lehman was a big difference before and after that
00:11:21after lehman had a tough time but we're down i remember the number maybe it's twenty four percent this is the group of fund of funds and it turned out that i think it was just todd combs at that time but todd had been hired and that warren had
00:11:35been asked questions in his annual meeting about the performance of the stocks in berkshire berkshires portfolio and in fact the managers had significantly underperformed the s and p in that particular years a very short period of time but he conveniently in two thousand nine didn't talk about the
00:11:51bet in the subsequent few years he always put the results up which he still does right before lunch and he would say well as you see as you can see i'm losing so let's go to lunch and that was it that occurred until certainly when the s and
00:12:08p crossed hedge funds which is probably only two years ago two or three years ago and then this year was the this annual letter was not the end of the bet for all intensive purposes it is because it be very difficult for investors a market crash for that
00:12:23one to come back but he took that as an opportunity to announce it and i have a theory of why he did that now it's not something i've talked to him about but it's interesting that i think the story that he wanted to make this simple story of
00:12:37thes at this moment in time the data supports it in every way it possibly could so it was ah good time for him to tell the story that he wanted to tell and i really i've written a little bit but i haven't spoken or written much about the
00:12:52bet since it's amazing to read his most recent annual letter and obviously the two you get along you know he writes very very nicely about about the experience so at the very least you know what an awesome opportunity to be a part of the discussion and i'd like
00:13:08to go back then to to your thoughts from an investment perspective at the beginning of the bet about what you were what horse you were betting on the reasons for which you were willing to make the bet which may not be the ones that people think it's a
00:13:22really important question before that which we'll get to that in a second i think it's really important to make to reassert the point that warren made in his letter which is the's are high for hedge funds it's a significant hurdle to overcome fees are high for active management
00:13:40relative to passive and nobody should take that lightly in fact the fee burden was knowable ten years ago so the existential question of our hedge funds terrible because they charge high fees is to me it's not the right question because you could ask the question our hedge funds
00:13:56valuable if they charge no fees and then it sort of takes that question out of the equation so that's all information that i had at my disposal i knew what the burden would be in fact the burden was a lot less than i thought it would because there
00:14:10wasn't a lot of performance so they were in a lot of performance fees so the question really is what bet was i making and i wrote something about this at the time and and there's a piece that i've written that's coming out tomorrow about this that to me
00:14:26used the expression apples and oranges comparison lightly and it took me a while to figure out the right analogy and we can pull the thread on this analogy but i think the right analogy is to ask which is the better sports team the chicago bulls or the chicago
00:14:42bears and we can pull that threatened the more i thought about it the more i think there's a lot of relevant similarities and how do you how would you actually make that comparison but that's what this waas so you had a group of had trunks and we can
00:14:54talk about the merits of hedge funds and what i thought that would be and then you had the s and p five hundred and those are two different things at the time the s and p five hundred was trading near its historical high on a sugar p basis
00:15:07p basis whatever you want simple metrics but the s and p was expensive that proved out given what happened in two thousand eight and so if you thought that hedge funds were going to do something independent and turn along maybe generate a mid to high single digits return
00:15:22as long as you thought the snp would do worse than that that was a good bet in fact that was why i was comfortable making the bet and that was why at the time and even today i think the odds of winning that that in nine and a
00:15:33half years ago were very high because history would have told you that the s and p five hundred was likely to have a poor period of performance in that event you kind of want to bet on anything else head fronts happened to be the something else so so
00:15:47much of the conviction that i had in the wager had to do with the prognosis for the s and p and that was somewhat independent of headphones we could talk and we will talk about hedge funds and what i think hedge funds did and did that disappoint yes
00:16:00to some degree but that really was the core of the that that that i thought i thought warren was the patsy at the poker table because he threw out the s and p is the index i thought that was the wrong index to be picking and it was
00:16:14something that was going to be easy hurdle to overcome what's let's unpack the kind of item by item the differences in exposures between the basket of fund of funds and the s and p five hundred obviously we know we know what we're getting with the s and p
00:16:28five hundred which is you know the premier us based companies big caps that mega cap stocks has tended to beat all of the countries for a long long time i was speaking at morningstar conference this past week and jack bogle was one of the keynote speakers and he
00:16:45made a point again to say that despite the u s he said this despite the u s is valuation i remain completely all in on the u s at the expense of any sort of foreign exposure so us versus foreign is one of these kind of dynamics that
00:16:57i'm i'm trying to get at with the exposure's within the hedge funds but using your bulls and bears comparison that these two things are playing a different sport all together let's define why that is so what are the things or the variables or the exposure's in the fund
00:17:12of funds camp that are very different from the s and p five hundred we'll let the s and p five hundred go we know that that's a basket of large companies its earnings growth it's multiple changing multiple hedge funds it's an interesting starting point because hedge funds can
00:17:27be anything it's a catchall i think the contention in the bet or the intent in the bet is to compare the s and p to something similar to exposures to the s and p that has a lot of fees to it but that's not what hedge funds do
00:17:42and in fact let's just set aside the part of this that we did include in the back which is equity long short hedge funds there are hedge funds that invest in debt security their hedge funds that invest in commodities and currencies and rates in esoteric exposures like all
00:17:58kinds of different financing vehicles here maura maura about talked about music royalties on one of my podcast episodes so that's a completely different comparison but for the purpose of the bet let's think about equity long short hedge funds the two key differences are the level of market exposure
00:18:15where the s and p five hundred every dollar you put the work is a dollar exposed to the market and in this group of hedge funds and most hedge funds let's just say for simplicity it's about half of the exposure to market so you're along some stocks your
00:18:27shorts and stocks the net exposure long's minus shorts is about half the exposure markets over a long period of time just the beta or the market exposure of the snp goes up fifty percent you'd expect the hedge funds to go up twenty five percent the other big piece
00:18:43of it is a large camp us stocks versus other and in this case the other a lot more globally diversified ah lot more waited to mid and smaller caps and there's there's that kind of interesting question of what's happening with the s and p side now if we
00:19:00could talk about but that's the exposure the key differences in the exposure of the hedge funds or there's less market risk and is a more diversified market risk can you unpack this idea of not on the feast side but on the valuation side again back to your one
00:19:13of the original kind of key things you felt you had in your pocket when you made the bet was that the s and p was expensive and to be clear all the research that everyone's done shows that valuation matters and i think the way you put it his
00:19:25price matters eventually right that you don't the timing of it is a very difficult thing to get right and the dispersion of outcomes khun b wide so you can start an expensive period and end up with good results you could start cheap period end up with bad results
00:19:39it's said that the average is work out in your favor to be a value investor soto unpack this idea that you wrote about in your pieces well about price mattering sort of eventually so i'm going i'm turning the tables on this is a conversation on interview so you
00:19:52have done a lot more work that i have on valuation the simple version i used was when you start with a high price or high evaluation you get poor result but i think you know the data much better than i do about this yes so using schiller p
00:20:08specifically which is probably the most quoted one and maybe the cleanest there's problems with it like there is with an evaluation multiple but it's probably the cleanest historically and a lot of people have really unpacked this this idea so for those that don't know the specific calculation basically
00:20:23you take the trailing ten year period of time earnings for the s and p five hundred and you inflate up older earning so you adjust them for inflation so that you're not effectively underweighting the older earnings because there's inflation over time and you you look at the kind
00:20:40of current price relative to a normalized expected earnings and the reason ten years isn't precise science it's it's it could be five years it could be seven years it all kind of looks the same you want to capture a cycle so historically speaking the average schiller p is
00:20:55probably sixteen seventeen something like that but there's definitely two regimes and one is sort of pre early nineteen eighties and won his post and the average post nineteen eighty is is much higher setting that aside for a second when you look at the correlation relation between the current
00:21:13schiller p e and the future ten years of really returns in the market it's very high it's something like point seven point maybe even hired in that point seven point eight so pretty reliably what that means is if you buy low and wait ten years you get a
00:21:29pretty good really return if you buy high at you know twenty five times plus schiller p e you're going to get a bad result and that's worked out pretty well in the most notable example would be nineteen ninety nine when it got to you know forty or something
00:21:42crazy like that we're at thirty today only the third time everett thirty today so it's been a good bet to your point about him being the patsy at the table the odds we're in your favor let's put it that way but it didn't work out that way and
00:21:57so i find that to be the most interesting part of this bed and one of the questions will get too is would you make the bed again You and i have talked off flying quite a bit about that and we'll get nuanced into it but the case that
00:22:08you had in your favor at the beginning of the bet is even more so today given how expensive markets are so what do you think Do you think that people have interpreted this the right way You know you said i said silly and you said no it's not
00:22:21silly so what do you think about people's that what people are taking away from this which is basically don't buy hedge funds they're too expensive by the s and p so i think it a lot depends on the audience so the audience that warren is playing to that
00:22:35jack bogle is playing too is my parents and my parents were a teacher and a doctor they don't know they have no reason have an edge and i think everyone in that boat should have a low cost approach to investing do i think that low cost approach to
00:22:54investing by definition should be the s and p five hundred absolutely not um that is a bet that as you said jack makes and warren likes to make that the us is the best country in the world the u s should outperform everything else and i think that's
00:23:07a fair bet people can make that bet but people who don't know that they're making that that should probably invest in a more diversified portfolio globally and probably across a wider selection of securities than what the s and p five under really represents so that's the less sophisticated
00:23:25audience and that's the audience of the masses and i have no problem with that is i think that's the right advice in fact that the same advice david swenson made when he wrote his second book and then in his in his annual report this year he talked about
00:23:37praising active management than yale's success in that regard i just think that we have a trend that's happened now with passive investing and particularly the s and p five hundred that is setting people those people up for disappointment in the same way that it did ten years ago
00:23:54now the trend of investing in the s and p five hundred wasn't in place in two thousand seven but were it i suspect that a lot of people would've bailed out at some point time into the house isn't eight in fact from the beginning of the bat told
00:24:08called february two thousand nine yes be dropped fifty percent so that's my take on sort of low cost investing and whether to be the snp or abroad i actually think that i have almost nothing to do with hedge front and the merits of hedge front so again let's
00:24:24just focus on long short equity hedge funds because i think there's a tremendous amount of merit in everything else So the notion of hedge funds even is an institutional asset class that was popularized by dave swinson was this notion of absolute return and that's somewhat as opposed to
00:24:40relative returned and it's tried to generate some another equity like stream of income or extreme of returns that's less correlated We're not correlated with equity markets all of these other things again distressed debt if you have ah fantastic currency trader or interest rates trader all of those things
00:24:58fit that bill to a tee equity long short is this sort of existential question which is can this succeed in the way it has in the past That's easy no it can't it's more crowded you have an interest rate environment that makes the cost of doing business both
00:25:13from the real your return on your cash balances and short rebates just more expensive and then there's crowding meaning mohr people are playing the game which means stocks are much more shorted and that changes the dynamics and the ability of someone too short a stock and hold onto
00:25:31it and so it's just to give an example i remember my early days in this business a crowded short had two or three percent short interest outstanding and today those numbers air you know fifteen twenty it's just a completely different game and so where i've seen long short
00:25:46equity funds continue to generate the types of returns their investors expect are outside the us particularly in asia and then in certain sectors that aren't we talked about this i think when we were having a conversation with brent certain sectors that air just less trafficked by hedge funds
00:26:03ahead twins tend to traffic in technology where there's a a lot of winners and losers and consumer names where they can walk into the stores and understand them and you see that in the data there are certain sectors where headstones participate particularly in us names i happen to
00:26:16think that some of the smartest people in the investing business are sitting in hedge funds because of the high fees the research and development effectively in hedge funds is much more extensive than it is more broadly in active management i think where there are winners there likely to
00:26:31be in the hedge funds the question is can they win by enough to justify the historical fees and in a lower interest rate environmental law return environment you're seeing the scrutiny that's kind of interesting for toe look forward because hedge fund fees or coming down so we can
00:26:49go to the limit of that and say if hedge fund fees were zero are effectively the same as vanguards fees would you invest in long short funds and i would i would invest in some and not others even if there were no fees so you're seeing the investors
00:27:01understand you're in a different environment and bringing the fees down that means more of that return will go to the investors and you know that accrues better for returns of a next period time so there's ah popular trend that it probably started with this paper called buffets alfa
00:27:18which wass distillation a couple guys to make ur wasn't as a collection i think was three authors and the paper basically said okay here's buffets track record how could you replicate this with factors and it was basically like value investing quality investing a little bit of leverage it
00:27:36was you know a straightforward formula which obviously that's ex post like you would have had to know that formula fifty years ago which don't even know what a factor was back then so it's a little bit of it of a game but but it kicked off this siri's
00:27:48of academic papers that basically said okay here's a category of an alternative that could be mid market private equity it could be private equity in general could be hedge funds long short hedge funds credit hedge funds what have you and here is a cheap alternative that would have
00:28:03given you the same exposure so don't buy private equity to just go buy a mid cap value ut f or don't buy lower market private equity go by leveraged smallcap us equities or something like that so one of the most interesting points about the bet is that if
00:28:18the fund of fund fees i'm pretty sure this is right correct me if i'm wrong if the fund of fund fees had been zero you still would have lost so it's a it's a good point to show look it wasn't just fees obviously fees are high if you
00:28:30can get two strategies that air equally good pay the lower fee of course and that's been the key lesson in markets in the last five years but what's your take on perspectively so looking forward this idea that most of the kind of hard to access exclusive alternative strategies
00:28:47that charge to in twenty or more can be replicated with some version of a public market cheap alternative there's a lot of subtleties in the question if it's the right questions a great question one of the things that's tremendously different today than ten years ago as you point
00:29:04out is people like you are have made these concepts into products So whether it's f sor factory tfc or they call it hedge fund beta there are certain strategies that you can replicate in a relatively simple way i think that by the time you can replicate most of
00:29:23those strategies the advances that they have has probably gone away so we know that you can now replicate what warren did fifty years ago my guess is for the next fifty years you're not going to have the record that he did if you replicated the same strategy so
00:29:40what you end up paying for is really two things one is that hedge funds are pretty flexible and so there are certain managers who you can then say okay we can replicate the style we can just buy their holdings at least on the long side but those there's
00:29:57some insight that goes into that and this is this is kind of similar to the kasparov chess deep blue yeah that the optimal strategy isn't the computer and it's not cast brought that sort of the computer with a reasonably good practitioner sitting next to them I think it's
00:30:12the same thing mohr and mme or you're going to see the costs come down because the leverage smallcap strategy can now can be replicated in kiev but that doesn't solve the question of should you buy the lever smallcap strategy and in fact most of hedge fund investing or
00:30:29most of the allocation to hedge funds and most of the dollars do not go to some nets strategy They go to a multi strategy fund where part of the delegation is thie insight of the people on the ground to nowhere to rotate the capital too and that becomes
00:30:44an important differentiated but important driver returns it's a combination of strategic asset allocation tactic out asset allocation and then bottom up implementation and that's on the core strategies on this esoteric stuff you wouldn't go back to music royalties there is no there won't be an index for music
00:31:01royalties or insurance settlements or litigation claims or those types of there's all kinds of interesting niche things and that's the r and d i can't tell you what those strategies will be going forward i can tell you that it's it's on the short side or if it's a
00:31:16new kind of area that bank's used to do and aren't doing anymore it's the hedge funds that we'll figure out how to make the money there's just such a fascinating ex anti x post you know after the fact before the fact dynamic here where because we have data
00:31:29and technology that we do now every single successful investment story can be retrofitted to some concept and so so much investment writing and research is to say what has worked how can i replicate that and do it as cheaply as possible into the future And i've even heard
00:31:46a q are described as the vanguard for alternative strategies that they're basically distilling down the exposures that have led to the success of different categories and offering it for cheaper i mean it's brilliant from a from a business standpoint and they've been enormously successful but the real question
00:32:04and kind of where i want to go next is for whom is inappropriate to buy any sort of alternatives like at what level you mentioned the mom and pop that you know the baby the dentist the doctor they shouldn't be buying an alternative manager so at what stage
00:32:18does it become potentially a good idea for what level of sophistication or assets does it become a potentially a good idea to view the alternatives asset class if it isn't even an asset class as something that's good for a portfolio i don't know if it is determined as
00:32:34much by size as it is by resource is on what i mean by that is it is the case that the dispersion of returns in alternatives could be hedge funds private equity venture capital it's all kind of the same in this regard the dispersion of returns is much
00:32:49wider than it is in active management the public markets and therefore if you're able to access the better town and there's a real question but you know what is that predicted going forward but let's let's assume the market knows what the better talent is can you get enough
00:33:04information from your team to understand who is that market who were the better players and then if they have limited capacity do you have the right type of capital behind you that you can access it if you don't have a reason and that lets call that an allocators
00:33:17at it might be the sophistication the allocator it might be the type of capital it might be the way the history of their relationships if you don't have that allocators edge and you don't think you should have it you probably shouldn't play the game in fact that's the
00:33:29point that david swenson has made over and over and over again it's not that yell who's poppy who has been the best at this for thirty years shouldn't play it's that if you don't know that you can play the right way you shouldn't play and probably the best
00:33:42example i know that it's calpers so calpers had their hedge fund allocation that was a very small part of what they were doing they were the first pension fund back in two thousand to announce we're putting a billion dollars in hedge funds should have been a great time
00:33:57to do it but calpers does things in a certain way and it's a difficult governance entity it's difficult to get things done there are a lot of interests pelo little and otherwise that go into the investment decisions and it wasn't surprising to me that after a long period
00:34:12of time they had very subpar results they were not set up tohave the right kind of investment edge and then as a result a few years ago they said oh we're abandoning hedge funds and people some people took that as a statement that hedge funds were a bad
00:34:27thing no i think it was a fit hedge funds they couldn't put enoughto work to make it meaningful for them they hadn't put it to work in such a way that they in particular had delivered good results and it takes up a lot of board time because unlike
00:34:40a traditional investment even if it's active there's a level of sophistication and understanding what should your expectations be of a hedge fund and are you meeting those expectations and it's not a simple as here's the s and p here's hedge funds here's how we did there's so many
00:34:55subtleties in it that if the less sophisticated the decision making body the more they're just going to react to performance and as we know that's always a recipe for disaster i talked teo david salem recently that episode will come out after this one but one of the things
00:35:08we talked about is the question of whether or not hedge funds or really any alternatives should be thought of as a bucket or as an asset class and his contention was no that one of the unfortunate perversions of the yale model or swenson successes that people have too
00:35:23many buckets there that they're trying to fill and that really there are only two buckets which is told a return and hedging something that offset to risk and so it brings me to two questions the first of which is do you agree with that formulation that hedge funds
00:35:37are not an asset class There are contractual arrangement that's a fee structure basically and to mr more interesting one is the bet was based on total return if you were to do it again how would you structure how would you determine what would be the metric or metrics
00:35:53that you would use to determine who won or lost because obviously hedge fund implies some sort of reduction of volatility or some sort of hedging component and that wasn't a part of how it was determined who want our law just i think on sharp ratio it still would
00:36:09have been the s and p five hundred but i love to hear about whether you agree with salem's formulation of no there's just two buckets and to how you would determine the winner of the bet if you're starting it today and looking forward for another ten years so
00:36:21one of the things i'm really enjoying exploring on my podcast is the different frameworks that allocators used to think about here's a big pool of capital how should i structure and i saw two things at yale one was this discussion of a certain asset allocation structure and the
00:36:39other was the discipline that having any asset allocation or in this case asked allocation but a structure imposed on the practitioners the investments office and the committee such that they knew what they were trying to accomplish and they could stick to it so total return and hedging is
00:36:57one you know when i had brett barton he talked about hira strategies and lower strategies is another ah david swenson's notion is that there are there are buckets that you could create that have certain characteristics and that those characteristics share what yale's objectives are very long term equity
00:37:15focused and liver the less liquidity maybe is another one yeah not really i mean that that's a great what we take a quick aside on that when when david got to yell the traditional portfolio was sixty forty stocks bonds and he said well we should be more equity
00:37:28oriented because we have perpetual capital and we should be more diversified than just stocks but if you start with just stocks and bonds by definition everything else is less liquid so it wasn't and there is there was part of it one of the many many thought processes he
00:37:43had was well since we're long term we should get paid for liquidity but that didn't even have to matter if you were going to diversify away from sixty forty by definition everything else had to be less liquid and that was one thing i think people misinterpreted it in
00:37:55what he did so circling back i think there are a lot of frameworks i go back and i saw the discipline part of the way The asset allocation framework works of stocks bonds and our national stocks hedge funds absolute return as a bucket private equity venture capital the
00:38:13way that i saw the discipline of re balancing so the continuous practice of effectively buying low and selling high as long as you think that those asset classes relative to each other are more volatile than there are one directional that adds a little bit of value and the
00:38:26ability to communicate with the committee and say these are our targets we want to shift it let's shift it this way and keep people on board was so powerful i think that was as big of a component as just that particular asset allocation strategy the problem with total
00:38:41return and hedging is how do you avoid all of the behavioral biases that come up in the decisions that come in the middle of that so that's separate so that let's just talk about hedge funds I think that there are certain types of hedge fund strategies that have
00:38:58a different return and risk characteristic than other things so if if you thought of it is a more liquid markets bucket of other that wasn't long equity markets in the u s or internationally i don't know where you put that but there's something to it more and more
00:39:17any of these categories you could take an equity long short hedge fund and say well that's an equity strategy and if it doesn't beat the equity markets and we have a long term prize and we shouldn't bother with that i think that's a fair point people can make
00:39:30that decision you could say distressed that is a credit strategy actually as equity characteristics maybe it should be in an equity bucket maybe it should be in a credit bucket maybe it should be in a private equity bucket all of that is fine and i don't have ah
00:39:42ofyou that everyone should do things one way because so much of it should be driven by what air the needs of that institution or person on the cult liability side that should drive what the asset mixes i don't feel that there is one way to do it i
00:39:57just have seen a few ways that have worked so well and i think i understand the reasons why they worked well that i tend to be biased to that more than sort of an open more flexible strategy so now how would you structure the bet how would you
00:40:11know what would be the metrics that or metric ideally that you would use to compare the two the two options so one of the one of the overlying aspects of everything we're talking about is this granularity and benchmarking right the more that we put h u r puts
00:40:26hey we've got a benchmark for that particular strategy therefore there's no alfa there's no there's no added value so look we could do that we could say let's pick this group of hedge funds will make it fun to funds let's make it a liquid alternative let's figure out
00:40:42what the net exposure to the market is let's adjust the index so that it's the same composition of net exposure and you could create a benchmark custom made that would tell you are these hedge funds adding value relative to their fees oh by the way all those targets
00:41:00are going to move right that might move annually than my quarterly they might move more frequently so then you could say well should we adjust the benchmark or what are we measuring Are we measuring stock picking ability Are we measuring the ability of the manager to shift their
00:41:13exposures so it's wanted pause there because there's a really important distinction to be made here when picking the benchmark and sort of splitting the skill if you will of a manager into two categories this is the classic allocation versus selection so part of your success or lack of
00:41:29success is going to be do you choose the s and p five hundred and you choose the cia yeah qui do you choose the russell two thousand or do you choose large cap stocks on and that is a decision that active managers need to make or implicit in
00:41:42their decision making process they're buying smaller cap stocks that's that's ah it's both an allocation decision meaning small caps will perform differently than large caps but it's also which ones you choose so to your point about do you adjust your benchmark for allocation every year i don't think
00:41:57you can because if you're on the other side of the bet that isthe because those allocation decisions are real decisions and are important very important to performance so it's incredibly tricky to determine what the benchmark is and maybe that may be the cleanest thing is just the s
00:42:12and p five hundred but maybe it's not total return that is the measure of success maybe you do it just for some measure of risk maybe it's a sharp ratio maybe it's something else so let's just let's just put it out there if you had to choose it
00:42:26was still the s and p five hundred it's not some customized benchmark that's the bet and you get to choose what the metric is of success it could could be total return again maybe given how expensive the market is today you might still choose that but what would
00:42:40you choose to parts what would you choose us the measure of success and if you had to choose five things again would it be fun to funds or would it be something more tailored and specific so let's start with just the bet itself as this would i go
00:42:54back nine and a half years knowing what i know today after having lose you certainly presumably losing would i make the bed again i would make the bed again over and over and over again enough times so that the odds played out and i really do think that
00:43:11you had two things happened that were unexpected one is the s and p performed in fact i think from this starting schiller p e evaluation from nine and a half years ago this was the best if not one of the best ten year period ever the other thing
00:43:28that happened was and really started post lehman hedge funds disappointed hedge funds in the past say equity long short hedge funds had a certain kind of capture of if the s and p went up ten percent you might expect them to make five or six percent and if
00:43:45it went down you'd expect them to only lose into three percent and that kind of upside downside capture didn't really work and i think some of it was because of increased competition and asset flows coming in so and there are also things that i just don't know right
00:43:59well if you look at the beginning of think it is two thousand thirteen or even the beginning of two thousand fifteen or sixteen it looked like a great period of time for headphones there was all this you could measure that benchmark and scrutinize it and however you however
00:44:13you got it so it was just right that turns around performing that afi's and then one day they stopped and so there's something always going on in the markets that we can look back and think we understand it not so to start with i would make the bed
00:44:25again i might lose it again i might be wrong that maybe the fees were just too high and they can't overcome the feast but i think the odds were very favorable and i would make that bet again if i were changing it and let's keep in mind that
00:44:38this started as warren saying hedge funds can't beat the s and p and i said okay i'll make that bet there was no discussion of well shouldn't it be done this way or that way okay i think if you wanted to make it more about our hedge funds
00:44:53justifying their fees even if you just said well let's take a net exposure of the market and what maybe that's fifty percent and you can say if you wanted to be snp that's fine if you want to be saved morgan stanley world index that's fine too and have
00:45:08a cash return for half of it in the market return for the other half i think that would be a closer comparison to the sort of are the managers justifying their fees it's interesting that when you add up the total market cap of the s and p five
00:45:21hundred and it's become the default thing it's become the default asset that people sort of assume like this is the passive return or maybe the u s total market if you want to extend a little bit but if you add it up it's still a relatively small percentage
00:45:35of the world's assets meaning if you kind of if you put the s and p next to all the credit that's out there all the global stocks that are out there go down the list it becomes as you put it in your note it becomes an active choice
00:45:48just to pick the s and p five hundred so i think that's an important point for people to remember that it is sort of dominated the world of investing post financial crisis it's the best performing nature major asset or asset class it's incredibly cheap toe access it sort
00:46:02of has all the stars aligned in support of it so the next question would be if it is the s and p five hundred and now it's perspective right so it's not would you make the bet ten years ago it's would you make the bet today and you've
00:46:15already mentioned that there's probably more headwinds today setting evaluation aside there's more headwinds lower interest rates etcetera for hedge hedge funds and there was ten years ago would you still do it via fund of funds would you if you could just have a blank slate to say basically
00:46:31i haven't alternatives bucket that i get to fill with you no one five managers something like that how how would you handle that part of it so i'm going to answer that question but before i want to talk about your earlier point which is very true about the
00:46:44s and p five hundred and worried family world or arm or global represented portfolio one of the things that i didn't even pay attention to so we talked about yeah the market exposure should be less in this period of time this losing bet this period of time in
00:46:58the s and p did well that this period of time when hedge funds underperformed if you measured these fund of funds against the morgan stanley world index which is not the right index because one hundred percent invested it's almost a tie international stocks so everything but the u
00:47:14s are actually down over this manure period so there's something to that and i'm not saying that means that headphones were great they weren't but net of all the fees and the layers and something that was just closer to apples to apples was actually a tie in that
00:47:28period of time so that's that's inside the second one is this notion of yes yes mp has been great and this came up i just want to reemphasize it but this came up on your podcast with danny moses when money is flowing from active too passive and in
00:47:44particular the s and p five hundred which has been the biggest driver of inflows over this period you think about what happens in the market Vanguard gets more money for the s and p five hundred it's a market cap weighted index and they buy those stocks they buy
00:47:58google they buy facebook they buy microsoft they buy g in the right waiting's as long as money is flowing there into exactly that strategy and buying those names more than a it's buying other names it is next to impossible to outperform that index so what you've seen over
00:48:16time is that active management itself is cyclical and we happen to be in a period of time where the money flows or strongly going into passive and in particular the s and p five hundred and probably will continue to for some of the right reasons we've talked about
00:48:29there's a lot of money in the market in the hands of people that are less sophisticated and should be investing in these simple strategies i don't think we've reached that equilibrium but when you're going through that transition period of time it is incredibly difficult for any active managers
00:48:43to outperform case in point berkshire hathaway so in this exact same period of time has been probably the only period in warrants history where berkshire hathaway for the most part is underperformed the s and p five hundred for a prolonged period of time certainly the first five year
00:48:58period he had done ended a few years ago i haven't looked at the numbers to see what it would be for the whole period but that tells you something when warren himself in this exact same period of time has not been able to perform i would not draw
00:49:09to a conclusion to that that that means warren is any worse of a money manager than he's ever been so let's circle back to your question would you use fund of funds no that you would use something that's far more cost effective you might use hedge funds you
00:49:23might use lower cost hedge funds part of the reason for using fund of funds in the bat was just logistics that the five fund of funds and weren't put the numbers in haven't been all that stellar but nine half years later they're all still in business and they'll
00:49:37have a track record i think if you had picked five hedge funds there's a far greater chance you would've had to rotate among them and now you get into selection issues you could have done in index i suppose people scrutinized the hedge fund indexes for all kinds of
00:49:50reasons some of which i think are good some of which aren't the problem with hedge funds is that you're trying to make something representative you just wanted to be there in the game and at least with the fund of funds you sort of had these two layers you
00:50:00said ok the hedge fund managers picking securities that'll beat the market and they have to justify their fees are the fund of fund managers picking hedge funds sufficiently to justify their fees so would you those were hurdles frankly i thought the snp was valued so high that you
00:50:16just could slap on all the layers you want and you would have had something that generated a raid return that was going to beat the s and p then there's a real question of you know what would warn have said i mean he said nothing for four or
00:50:27five years and that is exactly what you expect right hedge funds protected capital poorly in oh wait but much much better than other alternatives and it took five or six years for the market to come back in this incredible rally to do so my strong suspicion is if
00:50:41that had continued or you didn't have this fed induced environment that created all this strength in the market we just wouldn't have heard much of anything from warren about the bat one of the things that i tracked closely and michael morrison who will be back on actually soon
00:50:54to discuss this among some other interesting ideas has been in the most interesting writer on this topic is he goes to the paradox of skill that you have absolute and relative skill we tend to focus on absolute skill because it's kind of tangible weaken sense it but really
00:51:09all that matters and markets is relative skill that if you've got you know ten phds in a room maybe thirty forty years ago that meant you were going to earn enormous alfa but now everyone has those ten phds and they're fighting against each other it's a relative it's
00:51:22a relative game so what's interesting to me about the how you measure the bet there's a million ways to do it you know what what if what if the bet was well okay if i think the s and p s expensive then i'm just going to go fifty
00:51:36percent and p fifty years and cash instead of you know hedge funds which might give me an exposure like that from a beta standpoint but the burden is to earn out earn a two percent management fee let's call it and then whatever the performance fee might end up
00:51:49being that's harder and harder because the people that you are fighting against and i joke my my buddy morgan household that what i really should have called this show was this is who you're up against because as you as you kind of scroll around this world you realize
00:52:04how incredibly talented thoughtful and smart that people are that are playing this game and to your point that's that's probably exaggerated in a hedge fund world and so for me that's the big question it's not you know are there interesting strategies and incredibly smart investors that seems to
00:52:19be a given the question is in a more and more competitive and more more mature industry can you find them Can you do it and i don't have the answer but but i'm sort of with you that i'm a value guy and and i think that the market
00:52:34is expensive but i thought that i remember started telling people around here that in two thousand thirteen on that we know exactly what's happened since then so it's it's not a timing tool there's a positive correlation between cheapness and future returns but but the dispersion is wide so
00:52:49it's a fascinating it's a fascinating question if you have to look back and and identify the most enjoyable aspect of this whole this whole bet what would it be Yeah that's that's easy i'm gonna start with the least enjoyable so at least in travel is the frequency that
00:53:02my friends say has that bet going especially when you're losing even when we were winning like it just doesn't really care easily the most enjoyable aspect has been getting to know the people involved so i have had the great fortune of a consistent stream of the least expensive
00:53:20dinners with warren and ted wessler and todd combs that's just been so fun not quite every year but pretty much i got to know carol loomis who was just such an high integrity and brilliant journalist and toe watch her who clearly she's biased towards thinking warren side was
00:53:41was going to win despite really sh she was the person who wrote the first story on a w jones and popularized this kind of concept of the headstrong back in nineteen seventy one on dh that article is fascinating if you go back i think it's called hard times
00:53:55come hedge funds the things that she talks about in that article about the challenges the hedge funds were facing in nineteen seventy one are the exact same things we're talking about today so there's no doubt that that meeting the people involved has been by far you know the
00:54:12most enjoyable part of the experience you and i share this passion the search in investing of trying to i think map out the landscape the opportunities thie asset classes whatever you want to call the different parts of the investing landscape the opportunity said i think you and i
00:54:28both maybe that's the most enjoyable aspect of what we do is just kind of discovery what about the landscape today thinking as someone that's just probably like me going to spend the rest of my life searching trying to understand all this stuff and then hopefully positions some capital
00:54:43that's profitable relative to just boring cheap simple alternatives fully acknowledging that's the right thing to do for a lot of people what aspect of the current landscape do you think is most interesting exciting an area that maybe you don't know the field as well as you'd want to
00:54:58and you're excited to explore well as you know even though i'm pretty sure this bat will be on my obituary when that time comes and i've spent a long time right the better part of last fifteen years just in the hedge fund space i don't really think that
00:55:11way i think about investing as you do broadly risk and reward and hedge funds are one tool for that and and we think we've talked about both online and offline the challenges that hedge funds face and particularly long short equity funds i think the single most interesting thing
00:55:28i've come across in this this time i've had away is something you've pulled the threat on over and over which is this permanent equity so more and more i can circle back to first principles of what i learned working for david swenson which is you have he has
00:55:42long term capital and therefore you should have equity ownership in things and all this hedge fund stuff came out of hey this is an equity like return stream that looks different which has merit if it works mohr and mohr as public markets or the things that people can
00:55:59easily access feel expensive you have to keep looking for things where you can own something that you guys hey that that actually gets me a really nice way to return stream and this permanent equity the brent be shores of the world the ten marks of the world buying
00:56:16small family owned businesses at four times earnings and yeah you have to find the right ones and i've talked with brennan but if you buy all of them you probably lose all your money so the index for that is probably minus one hundred percent so you have to
00:56:31be very very skilled to find the right ones and to figure out how to build that network but for those people who do it is not an activity that that i do but for the people who do it that seems like an incredibly rich opportunity set and like
00:56:44many rich opportunity sets you can understand why and in this case what's the hey why am i so lucky Well you have to be because there's no scale to it i want it i want to spend just one couple closing minutes on this idea because in the listeners
00:56:57know that i've talked to a lot of people about different aspects of this i have focused thus far on the lower movie could even called micro cat private equity or really private equity as as the her professors called it which i like that name as well So some
00:57:11part of this is the structure itself the permanent component and then the the second part is where i've focused it is okay well what do you want to buy permanently and those air those air kind of two different things So setting aside the micro cat part first what
00:57:26is appealing about just the idea off a permanent structure relative to the more typical fund structures out there from your perspective and then maybe we could kind of wrap up by by sharing a couple resource is for people that want to continue to pull in this threat so
00:57:43there's there's a couple aspects one is we know from the start that it's incredibly difficult to pull off so most people that are deploying capital have boards and so the notion of hey we're putting our capital somewhere and there's no easily define nable liquidity option as as that
00:57:58immediately narrows the universe from an investment perspective there are two things that if you're able to supply permanent capital you can easily understand that makes the holder of that capital advantage to relative if other people so the first is very buffet like if you can make the case
00:58:18credibly that you don't have to sell someone's business you become a more favorable buyer so if someone has bought it started built their own company over the years and they're nearing retirement age and they want to sell their baby they don't they may not want to sell it
00:58:35to a private equity firm who they know will hold it for five or six or seven years and then we'll sell to someone else they may want it to be preserved in some capacity and and warren has done this it bircher hathaway over and over and over again
00:58:48and has become the world's preferred purchaser of great businesses so that's that's a big one the other is that if you're the owner of that business and you have no date by which you need to sell it you can make different capital allocation decisions with a much longer
00:59:05time horizon tom russo who i'll have on my podcast in a few weeks talks about this is the capacity to suffer the ability of a business to suffer in the near term to basically encourage acres to reap longer term profit in this world and certainly a public company
00:59:23world it's just hard for companies to do that they are scrutinized on a quarterly basis the people who own their stock are scrutinized on a quarterly basis if not more frequently and so even in private equity and one of the great conversation to have a ted westerners probably
00:59:37only person that i know who's made this case ted went from investing he was a private equity firm and he switched to creating his own public equity vehicle and he said that the reason he did that was he felt like if they did a great deal with a
00:59:52great business it would take every year that went by four years five years six years they would realize more and more and more how great of a business it wass and he hated the fact that once you really believe this was an incredible business you had to sell
01:00:04it so he didn't want to be in private equity because he didn't like that time horizon and then he switched to his own public equity vehicle and sure enough he had a style it was very similar to warrants when he was off on his own i think there
01:00:16are some key strategic advantages for the providers of that capital if they can pull it off and then the people who possess that capital in their ability to source better companies and their ability to make great long term investment decisions so i have come across a couple things
01:00:31that i'll share now for people interested in this general idea and then if you have any with love to share emma's well before i do that if you want to see the summary version of kind of the case that we've talked about look back and maybe look forward
01:00:43around the bet there will be a piece coming out tomorrow in bloomberg i believe right so sort of an op ed of sorts by ted and bloomberg that you can check out if you want to save yourself i guess if you're still listening you want to save yourself
01:00:53than our but you can share that won the resource is that i think have been really interesting are public martin and ted just sort of alluded to it public market companies or ceos that are effectively portfolio managers buffet is obviously the most famous one but there's two others
01:01:11that i've come across quite famous which i've read the letters have read books about them and it's just fascinating the first is john malone who is a very famous name in in public markets but ah book called cable cowboy was very good summary of his long career where
01:01:27effectively he was a portfolio manager that bought and sold properties assets individual companies cable systems and his case was the primary vehicle but own pieces of all sorts of different companies and it was kind of a value investor in a fantastic compound er of capital so cable cowboy
01:01:43is one book the second is a serious of annual letters and i just finished the most recent one which was fantastic for a company called constellation software and effectively what that is is a like berkshire and almost decentralized collection of software companies so the parent constellation that forgetting
01:02:00the ceo's name and his team are basically buying up individual assets not meant not micromanaging them and they're kind of value investors they have a discipline like henry singleton did back in the teledyne days a sort of hurdles right that they have to clear otherwise they will not
01:02:15do the deal and he talks about in this recent annual letter the importance of discipline around that kind of portfolio manager mindset within a permanent capital structure There was a deal that he said he started getting heavily invested in because he had put so many hours into it
01:02:29and it just barely god was below their hurdle rate and they wouldn't do it because of that discipline just a few more examples of people that are interested in this sort of permanent capital holding company structure portfolio manager at capitol allocator i think that that is amazing flexible
01:02:45model that that i'll continue to pursue any books or or people or companies that you encourage people to check out as well yeah you know i don't know him that well that it certainly prem watsa fairfax is another example right right along lines what you talked about of
01:03:00someone who's overseeing a portfolio in a certain way there's ah bonus question that bears a quick discussion on which is this idea of thie s and p five hundreds time waited return assuming somebody bought at the beginning of the bet and held on through two thousand eight never
01:03:16made another trade and still holds it today versus the real world which is that there's volatility volatility induces trading usually in the wrong direction at the wrong time so maybe just riff on that for a minute on the importance of what actually investors earn in these vehicles so
01:03:34we all talk about the s and p five hundred today on the strength of the s and p five hundred today and for the people listening and anyone who's involved the asset management business it's been a source of frustration if you're an active manager but it also turns
01:03:45out that the who's ever sitting on the pool of capital whether it's the boards of institutions or a family officer an individual almost no one has earned the returns of the s and p five hundred over the last nine and a half years so why is that the
01:03:58case well it turns out and i mentioned this earlier that if you started investing in the s and p five hundred on the day of the bet fourteen months later you lost half of your money and very few people have the capacity to suffer it's tom says summer
01:04:14so says and stay in the trade so more often what happens is at some point in time people reach their pain threshold and they say oh my god i'm going to lose all my money they sell and then the market starts rallying in two thousand nine and sometime
01:04:27in late two thousand nine or two thousand ten they say oh okay like it's safe to go back in the water and if that were to happen the investor the dollar awaited return of the actual experience of the investor they would not have earned the returns of the
01:04:42s and p five hundred over this nine half year period in fact almost no one would have on the flip side head jones doesn't do anyone any great favors over this period of time but the draw down over that period was half for less than half which just
01:04:54means it was a little bit easier because the pain was far less severe for the investors to stay in so even though the balance wasn't a strong and the returns weren't as good there's just a better chance that at the end of the day the real world experience
01:05:08your pocketbook was going to be bigger even in this case investing in hedge funds on the market i was on the panel talking about smart beta with west gray who's a good friend of mine as well yesterday at morningstar and he made a great point which is an
01:05:19interesting aspect of success is that they have used the word cult sold to sell tissues the same word they've done an amazing job of convincing their investor base that they need toe hold these strategies for the long term now obviously it works out well for d a as
01:05:37a business because they've got incredibly sticky money but it has also worked out very well for their investors and they've tended tohave a lower behavior gap which is kind of what we're talking about here than say a simple s and p five hundred fun because they really have
01:05:51built this belief that this is the be all and all now the weirs and west brought that opposite is because it potentially is part of the explanation for why price the book has not done nearly a cz well and that's what they use is done has not nearly
01:06:04as well as all the other value factor so there's a bit of like sowing the seeds of your own demise in all of this but but this question of okay there's paper returns and then and there's really returns that really investors earn in markets whether you're a massive
01:06:18capital allocator you know with one hundred million dollars or your smaller individual investor and that's a key part of this equation what can you stick with right what what sort of strategy either can can you stick with because you have the discipline or mandates that you stick with
01:06:33it Maybe that's the private equity investment that locks up your capital for ten years and doesn't allow youto go in and sell in march of two thousand nine so we won't go into depth in that but it's a really good closing point which is this is all a
01:06:47paper exercise for the most part what really matters to me to you to everyone listening is what are your actual returns that you've earned and very often those air a lot lower than the paper numbers so discipline as always is is everything and as we continue to do
01:07:01these podcast in the future that will be another thing to focus on which is how do you set yourself up for success in terms of liquidity in terms of some of these other variables so a fun place to go and there's there's one closing point i'd make it's
01:07:13an undercurrent to the bet which is we all talk about him focus about how great the s and p five hundred spin but what we actually did with the money the collateral of the bet help perform the s and p five hundred by a mile and what that
01:07:30wass was way had pre funded the bet a million dollars ten years ago and he said look if we invest in something and it makes more than a million dollars that's great but we don't want to pledge a million dollars to charity and then not have a million
01:07:43dollars so let's just buy a zero coupon bond that'll create two million dollars in ten years again two thousand january one thousand eight after four or five years that amount which started i think is six hundred forty thousand dollars had grown to nine hundred fifty thousand dollars and
01:07:59you had about six years left to make fifty thousand dollars i called warren one day and said oh by the way do you remember what we did with collateral he started laughing because there's an afterthought and we made one trade and that trade was effectively to put it
01:08:09in equities up what we did in berkshire hathaway and now the collateral is i don't know it is it made like three hundred percent over this period of time so and that was that the real winner was the charities and cash not even the s and p five
01:08:25hundred and so you know to that point of well how do you stay in something or make the actual decisions we make that was not a sophisticated investment decision for any type of investment reasons and yet had by far the best outcome of anything we've been talking about
01:08:41Great Well this has been fun is always great to get finally really dive into the particulars around the bet The nuance beneath the headlines is always interesting for sure we know that hedge fund fees air high and high fees are not good but but that's not necessarily the
01:08:57whole story and so we will We'll keep the conversation going Thanks patrick everyone patrick here again to find more episodes of invest like the best go to investor field guide dot com forward slash podcast if you're a book lover you can also sign up for my book club
01:09:14that investor field guy dot com forward slash book club After you sign up to receive a full investor curriculum right away and then three to four suggestions of new books every month You can also follow me on twitter at patrick underscore Oh shag os h g if you
01:09:31enjoy the show please leave a quick review for us on itunes which will help more people discover invest like the best Thanks so much for listening No

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