Before the 2008-2009 Mortgage Crisis and during the heady days for third party research in the era of the Spitzer Settlement, Morningstar paid the bill for as many as a couple dozen analysts to attend the Berkshire Hathaway annual meeting in Omaha. I never went, partially due to circumstance and partially due to my constitutional contrarianism.
The last few years, I have been too busy with IOI to make the trek down, but I always enjoy reading the headlines from the meeting. This year, my eye stopped on two headlines in particular, one dealing with derivatives, and the other with hedge funds.
Buffett Says Derivatives ‘Time Bomb’ May Elude Auditors’ Review reports Bloomberg on April 30. The first thing to catch most people’s eye is likely the mention of derivatives. Many are likely to jump to a faulty conclusion that Buffett doesn’t like or use options.
Buffett is a very large investor in options of one sort or another* but people who don’t know the difference conflate his comments about complex, over-the-counter derivatives with the straightforward, listed financial tools that we discuss in IOI 103.
The derivatives that Buffett criticizes are worthy of criticism. These contracts run for hundreds of pages, the payoff conditions are often fabulously complex, and the underlying assets may or may not have an active secondary market. If the underlying instruments are not trading, the only way you can calculate the value of options on those underlying instruments is by making assumptions (e.g., if asset X was trading, it would be trading for $Y). This, in simple terms, is what is meant by “marking-to-model.”
These kind of derivatives really are financial weapons of mass destruction.
The thing that surprises me is that people read Buffett’s comments on derivatives and come to the conclusion that options are bad, but very few people come to the conclusion that Buffett explicitly states himself – namely, that there is no way to accurately estimate the value of most banks.
For example, Bloomberg quotes Buffett as saying…
“If you take the 50 largest banks in the world, we wouldn’t even think about probably 45 of them.”
Clearly, Buffett is a better investor than I am – as I mentioned in this article a few weeks ago, I’m shy about investing in any of them!
Another interesting topic of conversation coming from the Berkshire annual meeting was what an investing “bomb” most hedge funds are.
“There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investing abilities,”
Bloomberg quotes Buffett as saying in this article: Buffett Says Hedge Funds Get ‘Unbelievable’ Fees for Bad Results
One of the main topics of discussion in the IOI 101 course is the extent to which structural factors (mainly related to the compensation schemes of professional intermediaries) affect the actions of investors in aggregate. The “two-and-twenty” fee structure that was de rigueur for years in the hedge fund industry is a powerful influence on the way hedge funds do business – both in terms of asset gathering and of making investment choices. It is also one of the main contributors to the poor performance of most hedge fund investors and the main reason that more and more sophisticated asset allocators (like CalPERS) are pulling their money out of these vehicles.
This is not to say that the portfolio managers and analysts working at hedge funds are not smart people or are not, at least sometimes, good investors. The problem is not usually intelligence or training, but rather in the incentives of hedge fund professionals, which are most often poorly aligned with the interests of their principal investor clients.
The goal of IOI’s courses is to provide principal investors (who are naturally incentivized to do well in investing) with the training and systematic approach of a good hedge fund manager.
* He famously wrote a naked put option on the S&P 500 Index at the depths of the financial crisis. He has made an enormous amount of money on a position in Goldman Sachs thanks to warrants (which is just a share of stock with a call option attached to it). A large proportion of Berkshire’s profits come from insurance underwriting, which, as alumni of the IOI 100-Series courses will know, is simply another form of put option.