Currently occupying No. 2 and No. 3 on the Forbes Billionaires List are the two richest men in the United States: former Microsoft CEO Bill Gates and Berkshire Hathaway's (NYSE: BRK-A) Warren Buffett. While many on the Forbes list consider other occupants competitors, these two have formed a rather admirable friendship.
Gates also happens to serve on the Berkshire Hathaway board of directors. But even though they are both friends and business partners, the two titans don't always take each other's advice.
Source: Wikimedia Commons.
In fact, there's one interesting piece of advice that Warren Buffett gave -- and that Bill Gates ignored.
Don't mess with "financial weapons of mass destruction"
In one of Buffett's legendary letters to investors, he warns against the use of derivatives:
The derivatives genie is now well out the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
It should be noted that Buffett wrote this letter in 2002, nearly a half decade before the financial system was taken to the brink of ruin by a type of derivative: the credit default swap. Credit default swaps on poorly packaged structured products -- mostly mortgage and equity related -- proved Buffett right.
So how exactly has Bill Gates violated the Oracle of Omaha's prescient pronouncement? It's within the confines of the Bill and Melinda Gates Foundation Trust.
So, what's the story?
Bill and Melinda Gates have a two-entity structure: The Bill and Melinda Gates Foundation, and The Bill and Melinda Gates Foundation Trust. The foundation works to reduce inequities around the world, and its trustees are Bill and Melinda Gates... and Warren Buffett.
The foundation trust seeks to manage the assets before transferring them to the foundation for usage. And that's where those financial weapons of mass destruction lie.
In the investments section of the trust, there are derivatives. In fact, on a net fair value basis, the trust had nearly $41 million in derivative liabilities on its 2013 financial statement. And although it's prudent to mention that neither Bill nor Melinda manages this money, they could request certain investments to be excluded if they were so inclined.
The plot thickens
Berkshire Hathaway's most recent annual report also lists derivative-based transactions. The report states, "In 2013 and 2012, after-tax investment and derivative gains were approximately $4.3 billion and $2.2 billion, respectively." And although those gains provided 22% and 15% of net income in 2013 and 2012, respectively,Berkshire warns against judging its operating performance by this segment:
We believe that investment and derivatives gains/losses are often meaningless in terms of understanding our reported results or evaluating our economic performance. These gains and losses have caused and will likely continue to cause significant volatility in our periodic earnings.
With that being said, it is important to understand intent. Warren Buffett appears to favor index put options, a rather benign type of derivative. As far as The Bill and Melinda Gates Trust, the derivative exposure appears rather low when compared with the trust's size.
Know the rules
Although Warren Buffett addressed all derivatives in his 2002 letter to investors, it was apparent he was speaking not solely of the device (the financial product), but the intention. His diatribe was aimed at Wall Street's rampant disregard for risk when using the more esoteric derivatives that led to the financial meltdown.
Back then his his clairvoyance went unheeded, leading to a giant check to Wall Street from U.S. taxpayers. But with care, a long-term focus, and proper intention, derivatives can be used responsibly and profitably.
Although both Berkshire Hathaway and The Bill and Melinda Gates' Trust use derivatives, rest assured they have a long-term, sustainable focus rather than a myopic one.
