Buffett and Three Hedge Funds

The oracle at 93

Warren E. Buffett’s annual letter, released Saturday, was sobering in its report on Berkshire Hathaway Inc.’s beleaguered railroad and utility businesses. Berkshire, Buffett, and his shareholders (including me) are paying for the socialistic mood in various statehouses, particularly California, where regulators are increasingly abandoning the fixed-return model for utilities, which across the decades made them ultra-stable investments. A few states have “raised the specter of zero profitability.” In lay terms, legislatures want constituents to have ready access to electricity without having to bear its economic cost. Berkshire’s railroad, BNSF, is hurting from Washington-imposed wage settlements that ran well above projected inflation, and from other problems. Buffett characteristically took the blame for not anticipating the risks to each of these businesses. “I made a costly mistake,” he wrote with respect to utilities.

Otherwise, the report was positive on Berkshire’s large insurance holdings and on its operating profits generally (up 21%, despite a decline in the two problem units) and uncommonly sentimental in its tribute to Buffett’s late partner, Charlie Munger, who died just short of his 100^th birthday. Modestly deeming Munger “the architect of Berkshire” while he, Buffett, merely played the role of “general contractor,” Buffett, 93, wrote, “In a way his relationship with me was part older brother, part loving father.” Rarely if ever has the Oracle bared such feelings in public.

Finally, it was reassuring though unsurprising that Buffett continues to insist on a shareholder-centric model of corporate governance, in which duty to shareholders is compromised neither by managerial greed nor by political fashion. Or as Buffett, who as chairman and CEO earns a $100,000 salary and zero bonus, wrote: 

Berkshire benefits from an unusual constancy and clarity of purpose. While we emphasize treating our employees, communities and suppliers well – who wouldn’t wish to do so? – our allegiance will always be to our country and our shareholders. We never forget that, though your money is comingled with ours, it does not belong to us. [italics added]

Such sentiments stood in contrast to the governance philosophy evidenced in an illuminating report in the weekend Wall Street Journal on three giant hedge funds--Citadel, Millennium and Point72—each of which notched returns of “around 10% or more” in 2023.

Since the Standard & Poor’s 500 index returned 26% last year, you might think that investors would be clamoring to get their money back. In fact, they are banging on the door to invest more.

How else to interpret the obscene escalation in such funds’ fees? According to the Journal, rather than the customary hedge fund fee of 2% (or less) for expenses, these funds have moved to a “pass-through” model in which expenses such as technology, employee bonuses and, if they choose, the office Nespresso, are allocated to investors. The model of ‘we-spend, you-pay’ is not one to encourage thrift. According to a Barclay survey of investors reported by the Journal, investors in such funds “on average pay expenses equivalent to around 5% of fund assets. … In some cases, expenses can amount to more than 7% of assets.” This is in addition to the rich performance fee, typically a fifth of profits. 

The Journal reported that Citadel, Millennium and Point72 represent the hedge-fund industry’s “hottest strategy,” which is combining scores of investment teams, each with their ostensible differentiation of strategy, under one roof. According to the Journal’s admiring appraisal, “few have managed to match the success” of these three, by which it meant that within the mediocre universe of multi-manager funds (which achieved less than half the return of the S&P over the past five years), these three have done better than some others. Or perhaps the Journal appreciated what is meant by “success”—or rather, for whom the funds’ success is intended. 

The aim of Citadel, run by Ken Griffin, Point72, run by Steve Cohen, and Millennium, managed by Izzy Englander, is to increase the assets and therefore fees under their control. In this endeavor, they are indeed, to quote the Journal, “killing it.” Citadel and Millennium each manage around $60 billion, Point72 $32 billion. But don’t look for the customers’ yachts. 

Hedge funds are private businesses and free to charge a market rate.  However, to the extent that these large funds are marketing to institutions (meaning, the “investors” allocating money to Citadel, et. al, are investing other people’s money) incentives can—and often do—become badly misaligned. To wit, such institutional clients may be glad to forgo, over time, considerable economic returns for the supposed comfort of multi-manager, volatility-damping strategies. And they may scarcely blink at paying fees out of proportion with results for the privilege, or the perceived status, of being Ken Griffin’s client or, perhaps, sitting in the owner’s box of Steve Cohen’s fourth-place baseball team. It isn’t their money.

The mindset of these mega-asset collectors, hardly unique to the financial industry, resembles that of overpaid executives in other industries (did somebody say “Tesla”?) They regard investors not as partners but as pigeons. They practice their own form of socialism (socialism to benefit the privileged, mind you), extracting a tax on the owners of capital. Berkshire is different. Despite its 59-year record of success—the fruits of which have been distributed in equal proportion among all investors, including the CEO—the Buffett model remains more the exception than the rule.