Sunday, June 9

Week 101 - Is Berkshire Hathaway becoming a hedge fund for the masses?

Situation: The idea of a hedge fund is difficult to sell, even to those who are already wealthy. Why? Because investors value outperformance during a bull market more than they value outperformance during a bear market. Lets face it: we humans have a high-Beta brain. We don’t like playing defense with our investments. We tend to view bonds as boring and the 4 defensive sectors of the stock market (utilities, telecommunications, consumer staples, and healthcare) are only interesting because their bond-like stream of reliable dividends tends to keep up with inflation. Hedge funds are another bond-like investment but with a twist. Their managers are typically betting against an overvalued stock or bond if they can find one. This is done through a “short sale.” That means borrowing the stock or bond then immediately selling it in expectation that it will fall in value. When the fall in price satisfies the hedge fund manager, the stock or bond is purchased and returned to its original owner. In essence, the hedge fund manager borrowed $10 worth of widgets, then sold those expecting to buy them back later for $5, and will pocket the $5 profit. Had the widgets gone up in value to say $1000, the hedge fund manager would still have had to buy them back for return to the original owner, and would have lost $1000 plus interest on the loan.

So two things are happening with a hedge fund: 1) a value is being placed on poorly understood assets; 2) any asset that appears overvalued will get “shorted” and any asset that appears undervalued will get purchased. There is one important thing, though, that isn’t happening which is one reason why hedge funds have a low Beta. Hedge fund managers don’t buy a risky asset with the plan of selling it before the risk becomes apparent to all and it falls in value. This means that hedge fund managers need the support of an expensive research staff to help discover poorly understood assets and determine whether those are over- or under-valued. That research expertise is why the already wealthy clients of a hedge fund are willing to pay big bucks, typically 2%/yr of assets under management plus 20% of any outperformance vs. the S&P 500 Index over a 3-4 yr period.

Where does that leave us “retail investors” who don’t have sufficient wealth to legally qualify as a hedge fund client? We are not in this game for sport. We are in the game because we don’t want to become a burden to our children during what is likely to be more than 25 yrs of retirement. Academic studies have shown that the average retail investor realizes only half of the performance that his or her asset allocation should warrant, for three reasons: 1) high transaction costs that come from using an intermediary; 2) borrowing money “on margin” to invest in stocks, and 3) behavioral factors (ignorance about how markets work and participating in the excitement of buying stocks during a bull market). 

Retail investors need to stop making the mistakes cited above and apply some of the lessons learned by hedge fund managers: a) avoid investing in “growth” stocks or mutual funds, which are typically those with a 5-yr Beta higher than 1.00 (the S&P 500 Index’s 5-yr Beta), and b) keep on the lookout for undervalued stocks, bonds, commodities, or real estate. It boils down to using the internet for trading and research.  

Are there any shortcuts that are less time-consuming? Perhaps a low-cost hedge fund-like investment for the masses? I would like to suggest that there are two: a) Berkshire Hathaway class B stock ($113.03/Sh at COB 5/29/13); b) the Vanguard Wellesley Income Fund ($25.32/Sh at COB 5/29/13). Both achieve the basic expectations of a hedge fund investor to perform better than the S&P 500 Index over two market cycles, to lose less than 65% as much as a low-cost S&P 500 Index fund (e.g. the Vanguard 500 Index Fund or VFINX) loses during bear markets, and to maintain low volatility (meaning a 5-yr Beta of 0.65 or less). 

This week’s Table has the details. It also shows how the 15 largest stock holdings of Berkshire Hathaway have performed much better than the S&P 500 Index over the past two market cycles (i.e., since the S&P 500 peak on 3/24/00) by returning 11.4%/yr vs, 2.4%/yr. On average, those 15 stocks (the mutual fund part of Berkshire Hathaway) perform much like VFINX with respect to 5-yr Beta (0.95 vs. 1.00), dividend yield (2.4% vs. 2%), and the extent of loss during the Lehman Panic (38.1% vs. the 46.5%) though you’ll notice that the 15 Berkshire Hathaway stocks did better on all 3 counts. You could point out that there are mutual funds you can buy, like the BlackRock Global Allocation A Fund (MDLOX), which achieve similar results with a 5-yr Beta of ~1.00. The special thing about Berkshire Hathaway is that it is an insurance conglomerate, and insurance companies typically have low 5-yr Betas because they have to maintain vast holdings of zero-risk funds (e.g. cash or US Treasury Notes) in the event of a calamity that triggers a large insurance payout. 

For Berkshire Hathaway, such zero-risk funds comprised 19% of its $427.5 Billion in assets at the end of 2012, and its insurance division accounted for 30% of earnings. It has the additional safety net of owning ~100 other businesses, most of which carry low risk. For example, railroads and gas/electric utilities comprised 29% of its assets in 2012 and 32% of its earnings. This explains why Berkshire Hathaway has a 5-yr Beta of only 0.25. Its stock holdings (mainly the 15 companies listed in the Table) accounted for only 20% of its assets and 15% of its earnings.

While perusing the BENCHMARKS section of the Table, you no doubt noted that there is an inverse correlation between cash/bond allocations and losses during the Lehman Panic. This should remind you that asset allocation has been proven to be the most important factor driving investment success. (The next most important factor is keeping costs low for both transactions and intermediaries.) While tax considerations are less important, you should fully fund any workplace retirement plan that you have (and a Roth IRA if you qualify), as well as regularly purchasing inflation-protected US Savings Bonds for your Rainy Day Fund (see Week 33). Taxes are never due on a Roth IRA, and are due on the others only when the monies are spent.

Bottom Line: The innovation we call a “hedge fund” contains valuable lessons for all investors. It teaches disciplines that can be added to the list of other types of under-utilized investment strategies such as dollar-cost averaging, rebalancing, reinvesting dividends and interest, and buy-and-hold investing. For example, BlackRock, Inc. started as a hedge fund and now has $4 Trillion under management (ah, yep you read that right). With a 5.25% up-front charge and a minimum investment of $1000, you can buy shares of their premier mutual fund called BlackRock Global Allocation A (MDLOX). It has the same volatility as the S&P 500 Index but otherwise incorporates their hedge fund philosophy. During bad times (such as the Lehman Panic), it lost half as much as the lowest-cost S&P 500 Index fund (VFINX). During better times (such as the last 13+ yrs taken as a whole), total returns averaged 8.3%/yr which was much better than the 2.4%/yr realized by investors in VFINX. Now for the kicker: The stock market has done well in recent years, with VFINX gaining 5.8%/yr over that past 5 yrs even though that period includes the worst part of the Lehman Panic. However, MDLOX has gained only 3.7%/yr over that period and only 2.6% so far this year. In other words, a good hedge fund will underperform (vs. the S&P 500) during bull markets and outperform during bear markets. Since stock markets have (over the past 100+ yrs) spent 2/3rds of their time either in a bear market or recovering from one, this is formula for success.

So think about investing in a poor man’s hedge fund like Berkshire Hathaway class B shares (BRK-B) or a low-cost bond-heavy balanced fund like Vanguard Wellesley Income Fund (VWINX). But you’ll say: “I’m worried about owning bonds because interest rates will rise when the Federal Reserve stops buying bonds at the rate of $85B per month.” Don’t be too concerned. Both the Federal Reserve and the managers of bond-heavy mutual funds have been (for the most part) buying only those bonds that mature in 7 yrs or less. Yes, those will decrease in market value when the Federal Reserve stops its bond-buying program (called Quantitative Easing 3) but they aren’t going to be sold at a loss. Instead, they’ll be kept off the market and held on the balance sheet until they mature. Supply and Demand for credit will remain balanced as the economy recovers, and more demand will bring more supply at more cost. That of course predicts a higher interest rate. But the market won’t be flooded with low-yielding bonds nobody wants to buy at their original price.

Risk Rating: 3.

Full Disclosure: I have stock in Berkshire Hathaway, and 4 of its top 15 non-insurance holdings (Table): WMT, IBM, KO, and PG.

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