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Warren Buffett’s Hedge Fund Bet: The After-Tax Effect

08/16/2017

Back in 2008, Warren Buffett made a famous “hedge fund bet” with Protégé Partners. He wagered $500,000 that the asset management firm could not outperform an S&P 500® Index fund over ten years using a selection of five or more hedge funds. Buffett’s hypothesis: hedge funds’ exorbitant fees don’t justify their returns over the long-term.

The challenger selected five funds-of-funds, which, when combined, invested in more than 100 individual hedge funds. The results so far? At the end of year nine, the S&P 500 Index fund was up 85.4% (cumulative return), while the average return across the five funds was only 21.2%!

That got me thinking: What would the after-tax results of this wager look like? At Parametric, we take tax management seriously because we know taxes represent an inexorable drag on returns—often larger in magnitude than management fees and trading costs. I decided to do the math to see how taxes would affect the outcome of this bet.

Spoiler alert, it’s not turning out well for the hedge funds. Notice in the following chart that the only fund-of-funds (FOF) that did reasonably well was the one most impacted by taxes. 

Cumulative Return, 2008 - 2016

Cumulative Returns

Source: Pre-tax return data was sourced from the 2016 Berkshire Hathaway annual report, pages 21-25, http://www.berkshirehathaway.com/2016ar/2016ar.pdf. For illustration purposes only; not a recommendation to buy or sell any security.

I estimated the after-tax return of the S&P 500 Index fund to be 78.0% and the hedge funds to be 10.7%. In other words, after paying dividends and capital gains tax along the way (but not accounting for a final liquidation), $1 million invested in the S&P 500 Index fund would have grown to $1.78 million, while the hedge fund investment would have grown to only $1.11 million. 

Active trading generates capital gains taxes that create a drag on returns. So, these taxes tilt the game even further in favor of indexing. A common retort from hedge-fund managers is that they provide lower-risk strategies, claiming to deliver equity-like like returns with bond-like risk. Therefore, they shouldn’t be expected to keep up with the S&P 500 Index. In this case, however, even the risk-adjusted returns of the S&P 500 Index are double the hedge-fund return before taxes and about triple the return after taxes.


Bottom Line

The lower-risk stance of the hedge fund managers, combined with their extremely high fees, make beating the index very unlikely—and taxes make it even harder. 

Not surprisingly, Buffett’s pending pre-tax win becomes a rout of the hedge funds after taxes. 

Potential Parametric Solution:

One of the primary drivers of tax efficiency in a Tax-Managed Custom CoreTM account comes from tax-loss harvesting. The Parametric portfolio manager will sell a basket of securities the majority of which are sold at a loss, and simultaneously replace them with a different basket of purchased securities. The trade results in net tax losses for the client, which can offset capital gains realized by other parts of the portfolio, such as hedge funds.


Paul Bouchey

Paul Bouchey, CFA - Chief Investment Officer

Mr. Bouchey leads Parametric’s investment, research and strategy activities. His research interests include indexing, tax management, factors, and rebalancing. Paul earned a B.A. in mathematics and physics from Whitman College and an M.S. in Computational Finance and Risk Management from the University of Washington. He holds the Chartered Financial Analyst designation.


1Pre-tax return data was sourced from the 2016 Berkshire Hathaway annual report. Without the K1 forms from the hedge funds, a few simplifying assumptions are needed to estimate the after-tax returns. I assume the current highest marginal federal tax rates: 43.4% for interest and short-term capital gains, 23.8% for qualified dividends and long-term capital gains. I assume that the ETF index fund does not distribute any capital gains over the period. I also assume that 75% of the returns from the hedge funds come from short-term trading and pay the higher tax rate (this assumption is in line with research on after-tax results of hedge funds). Taxes on dividends and realized capital gains are paid along the way, but no final liquidation tax is applied.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. 

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