No fun of funds

Last week hundreds of Gotrocks saw themselves suddenly transformed into Hadrocks as a result of the Madoff scandal. These were allegorical terms Warren Buffett used to illustrate the fallacy of paying for expensive investment advice. Wealthy people gave “funds of funds” such as Fairfield Greenwich or Tremont hefty fees for their role as middlemen, part of an industry that managed $1,200bn a year ago, according to Barclay Group. The fact that they failed completely in their role of vetting Madoff should convince investors to reconsider the industry’s value proposition. Had investors done some simple calculations they might not have given their money to such gatekeepers in the first place.

Consider the following scenario for annual stock market returns over rolling five-year periods: 5, 10, 15, 20 and -5 per cent for a normal compound rate of 8.7 per cent. Hedge funds typically take fees of “2 and 20”, their share of total assets and gains. A typical fund of funds tacks on another “1 and 10” for its “added value”, though Fairfield Greenwich was pricier with “1 and 20”, while Madoff charged no direct fees. A typical fund of funds would have to be superb at spotting talent as underlying fund returns must be about 5 percentage points better than equities overall just for an investor in the fund of funds to break even.

Earlier this year, Mr Buffett bet a prominent fund of funds manager $1m that a low-cost index fund would beat the fund of funds’ performance over a decade. Remember, this was not a bet on Berkshire Hathaway, which has outperformed by almost 11 per cent annually – just a passive portfolio. The master oddsmaker reckons his chances of winning are 60 per cent, which should be proof enough that funds of funds are a great vehicle for making Hadrocks out of Gotrocks. For those still convinced of such funds’ intangible added value, the Madoff debacle should be a wakeup call.

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