Where Are the Superinvestors?

Whitney Tilson argues that the exceptional money managers are in hedge funds.

Whitney Tilson
Whitney Tilson
Sep 10, 2004 at 12:00AM

The longer I'm in this business, the more I realize what a brutally competitive field investing is -- I'll show you the scars on my back if you don't believe me. And while the market rises over time, the reality is that over shorter time periods -- and especially during stagnant markets -- it's almost entirely a zero-sum game. It's like poker, in that a relatively small number of experienced, smart, disciplined, focused people earn disproportionate rewards at the expense of the many pretenders at the table.

Selfishly speaking, I should celebrate the irrationality of other investors, as they're the ones who create opportunities for prudent, long-term-oriented investors. But I don't. I view what I do for a living -- investing, as a profession -- similar to how a doctor or a pilot might feel about his craft. Just as it would drive a doctor or a pilot crazy if there were lots of rookies operating on patients or flying planes -- likely harming themselves and, worse yet, others -- I think that the number of people buying and selling stocks like madmen, with no sound strategy or any hope of long-term success, is an insult to my profession.

Who are the pretenders?
So who are the pretenders? Who are the people who, in just the past year, bought Taser (NASDAQ:TASR) at $64, Netflix (NASDAQ:NFLX) at $39, Veritas (NASDAQ:VRTS) at $40, Krispy Kreme (NYSE:KKD) at $44, and Sina (NASDAQ:SINA) at $49, and are buying Google (NASDAQ:GOOG) at over $100 today? Who are the people who were selling in a panic in October 2002 and March 2003, the most recent times when all sorts of bargain-priced stocks abounded? No one knows for sure, but my hypothesis is that, on average, the lowest-caliber investors are individuals (those who manage their personal accounts in their spare time) and mutual fund managers.

I know that I'm going to catch a lot of flak for saying this, and that many people will misunderstand what I'm saying, so let me be clear that I'm speaking in generalities. Of course there are many brilliant people who pick stocks in their spare time and do exceptionally well. Similarly, there are a handful of great mutual funds -- though sadly no more than a handful -- among the more than 8,000 of them (my colleague Zeke Ashton highlighted a few in these twoarticles).

But I stand behind three statements: (1) As I've writtenmanytimespreviously, few individual investors have the time, experience, training, and temperament -- the Traits of Successful Money Managers -- to become market-beating stock pickers; (2) Few mutual fund managers have these traits either; and (3) The relatively few full-time professional investors who do have these traits are disproportionately in the private investment management arena, most commonly, hedge funds (full disclosure: I founded and co-manage three hedge funds).

To support the latter two points, I can tell you that over the years I have seen the performance -- and more importantly, evaluated the underlying investment process -- of countless mutual funds, hedge funds, privately managed accounts and so forth, and there's simply no comparison between how often I find an extraordinary mutual fund (almost never) versus an extraordinary hedge fund (perhaps weekly).

To give you an idea of the difference in average performance expectations, consider that if a mutual fund outperforms its benchmark by five percentage points annually for a few years, it makes the cover of magazines, the manager is lionized as a genius, and billions of dollars flow in. In the hedge fund world, identical performance is greeted with a gigantic yawn. I know all sorts of managers who have beaten the market by 10-20 percentage points per year, even after fees, and profiled some of them in Buffettesque Superinvestors. Guess what? Almost all of them manage hedge funds.

Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) Warren Buffett's observations are similar. In his classic 1984 speech, The Superinvestors of Graham and Doddsville, he highlighted seven superinvestors (including himself and Charlie Munger, both of whom ran hedge funds for many years early in their careers). Of these seven, guess how many chose to build their careers via mutual funds? Only one, Bill Ruane, who founded the Sequoia Fund in 1971 (it's been closed to new investors since 1982). (In addition, Tom Knapp in 1968 joined Tweedy, Browne, which currently manages two fine mutual funds, but the firm ran only a hedge fund and managed accounts for 25 years until opening its funds in 1993.)

Why are superinvestors managing private funds?
Why might this be? Let's start with the assumption that only the top 1%-2% of all investors can substantially outperform the market averages over extended periods, as the market is very (though fortunately not perfectly) efficient. Let's also assume that such extraordinary investors can pretty much write their own tickets, since there is an endless supply of capital seeking market-beating returns.

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If you were one of these superinvestors, would you choose to:

(A) Manage a mutual fund, with all of the regulatory headaches, investment restrictions, daily redemptions by investors, etc. -- all for a 1.0%-1.5% management fee?; or

(B) Manage a private fund of some sort, with few regulations or investment restrictions, where you could pick your investors and lock them up to ensure a stable base of capital, and -- this is key -- earn a management fee plus 20% (or more) of the profits?

That's not a hard question, is it? It's little wonder then that over time the top talent in the money management business -- along with, unfortunately, a collection of shills, shysters, and charlatans -- has flocked to the world of private investment management. By one estimate, 900 hedge funds were launched in the past year and the industry is on pace to attract over $100 billion of new capital this year.

Some heap scorn upon the rubes who invest in such high-fee funds, hypothesizing (as Forbes did in May) that they are drawn by "an irresistible velvet rope, the allure of investing where most everyone else hasn't been invited to invest," but I think this is largely nonsense. We're talking about individuals and institutions that in almost all cases have at least $1 million of net worth (and usually $5 million of investable assets), so these are generally highly sophisticated investors. I believe they willingly and rationally pay higher fees because they think they've found a manager who's talented enough to generate exceptional returns, even after fees.

They might be misguided in this belief, of course. In fact, I think it's highly probable that the $800 billion hedge fund industry, in aggregate, cannot possibly outperform the market, especially given such high fees and how many untalented people are rushing into the business these days. (Some are even saying that hedge funds are becoming the dumb money in the market, though I don't think we're there yet.)

I'll even go one step further and say that the combination of too much money, excessive leverage, and too many gun-slinging hedge fund managers makes an industry-wide train wreck entirely possible, so I'm certainly not arguing that one should run out and buy a random collection of hedge funds. Rather, to repeat, I'm simply saying that the most exceptional money managers are disproportionately in the private investment management arena.

Efficient market nonsense
If you believe my argument, you'll understand the huge error made by the professors who publish studies showing that markets are perfectly efficient and those who try to outperform are doomed to underperform: they are only analyzing publicly available data, but the very best investors, in general, don't publish their performance, so the analyses of the professors are horribly skewed.

If what I'm saying is true -- that a high percentage of the best money managers is unavailable to the general public -- then what is the average investor to do? I suggest sticking to a mix of low-fee index funds and a few high-quality mutual funds, such as those Zeke recommended in his twoarticles, or check out the Motley Fool Champion Funds newsletter.

Longtime Fool columnist Whitney Tilson founded and co-manages three hedge funds and owned Berkshire Hathaway at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. To read his previous columns for The Motley Fool and other writings, visit www.tilsonfunds.com . The Motley Fool is investors writing for investors.