Tuesday, August 21, 2012

Buffett Versus the Hedge Funds

Given Warren Buffett’s confidence in beating hedge fund returns over time, I thought it would be interesting to take a closer look at the performance of Berkshire Hathaway (NYSE: BRK-A) and discern whether there is an opportunity for investors to try and construct their own mini-hedge fund out of it. The attraction of the question is clear. Buffett is the world’s greatest investor. Surely, if anyone can consistently beat the market, it is him. Moreover, if he can beat the markets (generate alpha) then why doesn’t he just leverage up and hedge Berkshire Hathaway against the index?
Now, I know what you are thinking. Another idiotic financial journalist trying to make a name for himself by peddling another contrived angle on the “Look ma’ I proved Warren Buffett is a lousy investor” theme.  And you would be partly right, the idea did tempt me greatly, I confess. However, I think any rational analysis would conclude that Buffett really is that good. He just is.

But I digress, back to the matter at hand.


Buffett vs. the S&P 500

Here is a graph of Berkshire’s per share book value versus the total return on the S&P 500. All data will be based on Berkshire's annual letters. The blue data is Berkshire. The red data is Berkshire’s relative performance against the S&P 500 since 1965. It can be taken as a proxy for the kind of returns that a hedged strategy might have returned.


The first thing to note is that Berkshire has only had two negative years! In comparison, it has failed to beat the index for eight periods within this data. Whilst ultra risk adverse investors would not like the performance of the ‘hedged’ strategy due to the larger amount of drawdowns, others might see the potential upside from greater returns from leverage. It’s time to explore this angle.


Buffett’s Uncorrelated Returns         

Hedging using leverage is all well and good, but there is a potentially nasty problem with correlation. Simply put (and it is very easy to put this in difficult language) if you are going to hedge against an index, then you need to be correlated (and co-integrated for that matter) with it. Why?

Because otherwise, we are not actually ‘hedging’ anything! Let’s put it this way -- we are betting on the time difference between Usain Bolt and Tyson Gay in a race. The runner’s times are correlated. They run in the same race.  Now consider that we are now betting on the difference in quantum between Usain Bolt’s time and the temperature on an island off Scotland. Two completely different things.
One way to see the relevance of Berkshire’s results relative to the S&P 500 is to perform a regression analysis of the type shown below.


The x-axis represents the yearly return of the S&P 500 whilst the y-axis represents Berkshire’s return for the same year. The key number to note is the R^2 number, which represents how much these returns are correlated. The closer it is to one, the more the correlation. As is evident, Buffett’s numbers are not particularly correlated! This creates a significant problem for a hedged strategy using Berkshire and the index.


What about Leverage?

Having established the problem of correlation, it is time to look at how leverage affects the strategy ... the underlying idea being that hedging is supposed to control volatility. If this is achieved and the strategy has a positive expectation -- with relatively few negative returns --  it could be argued that leverage will allow an investor to maximize returns. With this in mind, here is a range of outcomes for leveraged strategies based on hedging Buffett against the S&P 500.

 

The graph is quite messy but also very revealing. For example, 4x hedged leverage would have generated the best total return since 1965. However, note the huge drawdowns. I simply do not believe that any investor would not find himself psychologically affected by losing 80% of his money in one year! This is a key point because in order to generate the outperformance that followed, the investor would have to stay with the strategy. I would suggest asking the hedge fund managers that saw huge redemptions in 2008 whether this is a likely occurrence or not!

In addition, there is no late data for 5x because this strategy would have wiped you out in 1999. Furthermore, the ratio of 2.5-3x appears to work, but how on earth is an investor supposed to know this beforehand? The truth is this sort of knowledge is wonderful in hindsight but very difficult to predict at the outset.


Conclusions

The correct conclusion is that Berkshire’s lack of correlation probably makes it impossible to truly hedge with it. The reasons for this quality relate to the specific investment style that Buffett holds. By his own admission, it tends to underperform in strong markets but outperform in weak ones. However, this tendency is not so strongly correlated as to render a hedging strategy to be a foolproof approach.
For the retail investor, Buffett’s performance is an object lesson in what can be achieved with a disciplined long only approach focused on value principles.