Buffett Is Closing In on the $1 Trillion Mark --- Berkshire Hathaway has a smarter structure than a hedge fund, and that benefits shareholders

"In the never-ending search for the next Warren Buffett, most people are lost.

Hunting for a great stock picker is necessary, but not sufficient. You also need to find a great stock picker who isn't a pickpocket.

To do that, you need to think less about investing and more about investment management. For Buffett, his business strategy bred a structure that set him apart from other money managers -- and made shareholders a bundle.

A simple question illustrates this: How would Berkshire Hathaway have performed if Buffett had run it like a hedge fund?

Yes, I know you know the answer is "worse." Do you realize how much worse?

If you'd invested $1,000 in the S&P 500 in early 1965 when Buffett took over at Berkshire, you'd have a bit over $300,000 today. If you'd bought Berkshire instead, you'd have more than $42.5 million -- a big reason why thousands of adoring shareholders will gather in Omaha this weekend to hear Buffett hold court.

If, on the other hand, Buffett had charged hedge-fund fees, you'd have under $5 million -- still far more than the market, but about 90% less than Berkshire's actual results.

Put another way, if Buffett had charged conventional hedge-fund fees, his investors would have earned only about 10% of the wealth they have enjoyed -- and he could have been even wealthier than he is today.

I asked several researchers to calculate these returns independently: Andrea Frazzini, head of global stock selection at AQR Capital Management; James Carson, professor of insurance at the University of Georgia, and his former student Anthony Le; and Mila Getmansky Sherman, a finance professor at UMass Amherst, and her student Maya Peterson.

We assumed the hypothetical Berkshire hedge fund -- let's call it Berkaway LP -- charged a management fee of 2% of assets, plus a performance fee that took 20% of any gains above 6% (or, in one iteration, 8%).

Over a period when the S&P 500 compounded at 10.2% annually and Berkshire at 19.8% annually, Berkaway would have returned somewhere between 13.6% and 15.9% annually.

The real Buffett nearly doubled the market's rate of return over a 59-year period; hedge-fund Buffett would also have beaten the market, but by far less.

A Berkshire representative said Buffett was too busy this week to comment.

But I think investors would have earned even less had Buffett gone the hedge-fund route. That brings us back to Berkshire Hathaway's structure.

In the 1950s and early 1960s, Buffett ran investment partnerships that did charge hedge-fund-like fees (including a 25% cut of any annual return in excess of 6%, but no management fee).

But Buffett understood that structure should follow strategy, not the other way around. So in 1969 he announced he would close down his partnerships, and he ended up transforming Berkshire into an investment vehicle unlike any other.

Because Berkshire is a publicly traded holding company, rather than a mutual fund or hedge fund, it doesn't charge fees. And Buffett never had to worry that investors would flood him with too much money at a market top or yank it out at the bottom. Most funds have fickle capital; Berkshire has permanent capital.

Almost everywhere else in the asset-management business, investment vehicles charge fees at least partly based on a percentage of assets under management.

The bigger a fund gets, the more money the manager earns.

For clients, that's a problem for several reasons.

Asset-based fees focus the managers' attention not only on increasing the fund's returns but also -- and often primarily -- on increasing the fund's size.

Larger funds are cheaper to run -- but when fees are a flat percentage of assets it's the managers, not the clients, who reap those economies of scale.

Instead of seeking to maximize the internal cash flows from their investments, the managers are driven to maximize the external cash flows from their investors.

That leads many managers to hype their results at the peak -- drawing in performance-chasers who fling cash at the fund just as markets are overheating and stocks are overpriced.

The managers pour the new cash into overpriced stocks that then collapse in the inevitable downturn -- at which point the hot-money customers bail out of the fund, forcing the managers to dump stocks at the bottom.

Thus the fund is compelled to trade in response to its investors' behavior rather than to investment opportunity: buying more when stocks are less desirable and selling when they are more desirable.

The managers, though, prosper by collecting swollen fees at peak asset levels.

Buffett, meanwhile, has taken a $100,000 annual salary for more than 35 years and retains more than 216,000 shares of Berkshire's Class A stock, worth about $131 billion this week.

In theory, had Buffett run Berkshire as a hedge fund with typical fees and reinvested them all, Frazzini estimates that they would have added approximately $300 billion to Buffett's net worth by now.

In practice, that would have been impossible. Charging standard fees and having to kowtow to clients would have slashed Buffett's returns.

Yet most people keep ignoring Buffett's example. Institutional investors, and increasingly individual investors, have poured trillions of dollars into hedge funds, private-equity funds and other vehicles whose expenses can run as high as 6% annually.

These private funds are often structured, from the get-go, to maximize their size, rather than their rate of return.

A few mutual-fund companies, including Artisan, Bridgeway, Fidelity, T. Rowe Price and Vanguard, have shown the courage to close funds to new investors when markets get overheated. Some hedge funds also restrict new money when they run out of opportunities.

A few managers, including Orbis Investments, whose main office is in London, and Westwood Management of Dallas, offer portfolios that earn no fees at all unless they outperform their benchmark.

"It's a way of truing up the fees paid with the cumulative performance of the clients," says Dan Brocklebank, a senior executive at Orbis.

Such funds aren't always available to most individual investors, though -- and these fair fee arrangements remain discouragingly rare.

Part of the problem is that investors should be willing to share some of the upside with fund managers, but they dislike paying higher fees for better performance. AllianceBernstein, which offered a set of funds that charged higher fees for outperformance and lower fees when returns lagged behind, had to abandon them for lack of demand.

Until investors insist that funds change their structure and fees, and more fund managers cooperate, the quest for the next Warren Buffett will remain futile." [1]

1. EXCHANGE --- The Intelligent Investor: Buffett Is Closing In on the $1 Trillion Mark --- Berkshire Hathaway has a smarter structure than a hedge fund, and that benefits shareholders. Zweig, Jason.  Wall Street Journal, Eastern edition; New York, N.Y.. 04 May 2024: B.1.