Roulette

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

05/02/2018

On the eve of Berkshire Hathaway’s 2018 shareholder meeting—the event some have come to refer to as capitalism’s version of Burning Man—it’s worth looking back at a bold assertion its CEO issued a decade ago. In case you can’t quite recall, back in 2008 Warren Buffett made his famous hedge-fund bet with Protégé Partners. He wagered $500,000 that the asset management firm couldn’t outperform an S&P 500® Index fund over 10 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.


Protégé selected five funds-of-funds (FOFs), which, when combined, invested in more than 100 individual hedge funds. The results? It’s not even close: Over the 10-year period of the bet, the S&P 500 Index fund rose 126% (cumulative return), while the return to an equal-weighted portfolio of the five funds was only 35%. Even on a risk-adjusted basis, the hedge-fund portfolio had about half the Sharpe ratio of the S&P 500. Ouch.


The Buffett hedge-fund bet: What about taxes?

As lopsided as the results were, they got me thinking: What would the after-tax results of this wager look like? At Parametric, we take tax management seriously, since 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 have affected the outcome of this bet.


Spoiler alert: It still wouldn’t have turned out well for the hedge funds. Notice in the chart below how the only FOF that did reasonably well was the one most impacted by taxes.1

Cumulative Return, 2008–2017

Cumulative Return 2008 to 2017

Source: 2017 Berkshire Hathaway annual report, pages 11–14, http://www.berkshirehathaway.com/2017ar/2017ar.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 116% and that of the hedge funds to be 18%. 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 $2.16 million, while the hedge-fund investment would have grown to only $1.18 million. 


Why is tax so important?

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 returns with bond-like risk. Therefore they shouldn’t be expected to keep up with the S&P 500 Index. In this case, however, as the chart below shows, even the risk-adjusted returns of the S&P 500 Index are higher than the average hedge-fund return, and each of the FOF returns individually, after taxes.

After-Tax Risk-Return, 2008–2016

After-Tax Risk-Return 2018 - 2016

Source: 2017 Berkshire Hathaway annual report, pages 11–14, http://www.berkshirehathaway.com/2017ar/2017ar.pdf. For illustration purposes only; not a recommendation to buy or sell any security.


The bottom line

The hedge-fund managers’ lower-risk stance combined with their extremely high fees make beating the index very unlikely—and taxes make it even harder. Not surprisingly, Buffett’s comfortable pre-tax win becomes an outright 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. Parametric portfolio managers will sell the majority of a basket of securities at a loss and simultaneously replace it 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.


1Without the K-1 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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