Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Buffett: These investments are a 'fool's game'

Buffett's advice for the next 50 years

Warren Buffett has a message for public pensions, colleges and the like: Stop pouring money into expensive, high-end money managers.

"The commission of the investment sins listed above is not limited to 'the little guy.' Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades," Buffett wrote in his latest letter to Berkshire Hathaway shareholders.

Buffett has long been a critic of so-called alternative investing, a category that includes hedge and private equity funds, among others. The reason is the cut they take for their services, which can make billions of dollars for the managers but far less for clients, according to the man sometimes called "The Oracle of Omaha."

"A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool's game," Buffett wrote on underperformance.

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Institutional investors include pension funds, university endowments, foundations and sovereign wealth funds managed on behalf of countries.

Buffett already has his money where his mouth is. His famous "Million-Dollar Bet" with hedge fund-focused investment firm Protégé Partners is that a simple S&P 500 index fund managed by Vanguard would beat a mix of five funds of hedge funds over 10 years.

Through seven years, Buffett's index fund is up 63.5 percent while the five funds of funds selected by Protégé are up an estimated average of 19.6 percent, according to a Fortune report in February.

Buffett's renewed criticism comes as institutions are giving record amounts to alternative investment managers. Many view such funds as a way to limit risk and volatility in various asset classes, such as stocks and bonds.

Consultants and institutions argue that the distinguishing factor is picking the right managers. Buffett acknowledged that some do outperform, but said selecting them is too difficult.

"There are a few investment managers, of course, who are very good—though in the short run, it's difficult to determine whether a great record is due to luck or talent," Buffett wrote. "Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship."

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Alternative funds have long argued they do add value, especially if the goal is to help generate steady returns in the mid-single digits—performance that is designed not to beat the stock market in many years.

"Hedge funds help institutions provide retirement security for millions of workers and their families, scholarships and research funding for universities, and resources for grants and other philanthropic work to benefit communities across the nation," the Managed Funds Association wrote in its most recent annual report.

The average hedge fund return over the last 10 years was 5.67 percent net of fees, according to the HedgeFund Intelligence Global Index, which tracks funds across strategies. That compares to an annualized return of 7.65 percent for the S&P 500 index over the same period. (Many hedge fund strategies don't focus on stocks, making such simple comparisons misleading, according to industry proponents.)

The private equity industry also likes to tout its high returns: a PE benchmark average gain over the last 10 years ended June 30, 2014, is 14.3 percent net of fees, compared to 7.8 percent for the S&P 500, according to the Private Equity Growth Capital Council.

"Private equity has experienced strong investment volume because, year after year, it generates superior returns for institutional investors," a PEGCC spokesman said in an email in response to Buffett's comments.