Warning: Avoid these investments like the plague, says Buffett and Munger

As the Chairman and co-Chairman of Berkshire Hathaway, Warren Buffett and Charlie Munger have made more great investments than anyone alive.

So it pays to listen when the wise men speak.

So how should you invest? 

They recommend a diversified portfolio of index funds.

What about private equity and hedge funds?

Buffett and Munger say we should avoid them like the plague. 

Warren Buffett has plenty of brilliant friends, including Bill Gates. But he says Charlie Munger is the smartest man he knows. The 99-year-old Munger has long stopped caring about what other people think. But unlike (a much poorer) American billionaire with a blonde comb-forward, Munger’s bluntness comes from data that he expresses with parables of wisdom.  

In one CNBC recorded interview, he tells the story of a man with a nice-looking horse.  

That horse, however, is sometimes vicious, breaking people’s arms and legs. The man asks his vet, “What should I do?” The vet replies, “The next time he’s behaving well, sell that horse.”¹

Munger chuckles and says that’s immoral. But then he adds, “Haven’t I just described what private equity does?”

Private equity funds can buy shares in private enterprises, real estate, individual common stocks or controlling interests in companies. Hedge funds can do all of the above… and more.  

But on an equal risk-adjusted basis, private equity and hedge funds don’t beat the long-term performance of a diversified portfolio of index funds. That’s one reason Charlie Munger and Warren Buffett say you shouldn’t invest in them. The second reason is risk. Private equity investors rarely understand the risk they take.  

Unfortunately, the exclusiveness and lofty projections of private equity attract a lot of hopeful people.

If you haven’t read Robert Cialdini’s book, Influence: The Power of Persuasion, order it today.²

The psychologist explains how marketers influence us to buy. Cialdini calls one such strategy, scarcity. Who used it? Bernie Madoff (pronounced, “made-off” like made off with your money).

Before spending the rest of his life in jail, the famous private money manager falsely reported profits to the tune of $65 billion. It was other people’s money. His victims included pensioners and a who’s-who list of celebrities, including Steven Spielberg, Kevin Bacon, Kiera Sedgwick, John Malkovich and Larry King.

They all fell for the promise that their man could beat the market.

Madoff capitalised on the notion that his fund was “exclusive.” By refusing the money of several random wealthy investors, he increased the fund’s allure.³

Scarcity might sound familiar, if your friends or anyone you work with huddled up to whisper:

“Pssst. I have a special contact. I know a guy who knows a guy who manages an exclusive private equity fund. I could get you in.” 

That’s scarcity at its best.

Private equity managers often approach Warren Buffett (I think they're afraid of Charlie). Buffett might be the world’s most discerning financial analyst. As such, anyone trying to sell a private equity fund to Buffett would likely be several grades above the sort that you or I might find.

Yet Buffett says, “We have seen a number of proposals from private equity funds where the returns are not calculated in a way that I would term as honest.”⁴

Findings published in the Oxford Academics Review of Financial Studies say much the same thing. They also revealed that in a broad analysis, private equity underperformed the S&P 500 by 3 percent per year, and 6 percent per year on an equal-risk-adjusted basis.⁵

Buffett and Munger say private equity funds raise huge sums of money, from which managers and marketers skim off the top. It doesn’t typically matter how badly they might perform. Those who raise the money get paid no matter what. Mostly it’s naïve investors (including some naïve institutions) that take all the risk.

Madoff might be the most famous charlatan to steal people’s money. But his methods of deception get repeated every day. Private equity funds aren’t regulated products. That means there’s little recourse if someone absconds with the money to buy an island filled with monkeys in the Caribbean Sea.

Warren Buffett doesn’t believe all private equity and hedge fund managers are primate-loving crooks. But he says you shouldn’t buy their funds… even if they’ve posted great returns. That’s because we can’t decipher a manager’s skill from luck. And the managers often take far too much in fees.

It’s easy to find a private equity or hedge fund with strong past returns. That’s like sourcing last week’s winning lottery numbers. But picking a winning fund (or lottery ticket) that will perform well for your future is an entirely different thing.

In his 2016 letter to Berkshire Hathaway shareholders Buffett wrote, “I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds… that would, over an extended period [ten years] match the performance of an unmanaged S&P-500 index fund.”⁶

Ted Seides, of Protégé Partners, took that bet in January 2018. He picked five funds-of-hedge funds. He would have picked them (much as someone might select a private equity fund) based on promise and strong past results.

Perhaps those funds gained Seides’ attention, like Munger’s temporarily well-behaving horse.

But like that horse, the hedge funds then proceeded to break people’s limbs… badly losing Buffett’s bet. They averaged just 2.2 percent per year. Over the ten-year duration, they lost to the US stock index, the global stock index, the US bond index and the global bond index. Any combination of broadly diversified stock and bond market index funds beat those exclusive, hyped funds.

This brings us to today.

Global stocks and bonds have yet to recover from their 2021 highs. But according to portfoliovisualizer.com, over the 36 months ending April 2023, a portfolio allocated 60 percent to a global stock index and 40 percent to a global bond index is up about 28 percent, measured in USD. Portfolios with a value stock and small cap value tilt, such as the typical DFA portfolio, performed even better.

In contrast, the average surviving hedge fund gained a total of just 10.8 percent over the same three years.⁷ Portfolios of index funds made almost three times as much.

Yes, your portfolio of index funds is likely valued lower than it was in 2021.

So, now I want to see if you can pass an important test.

Do you have the mettle to maintain a globally diversified portfolio of index funds? If you have an income, do you have the fortitude to keep adding money? Do you have the strength not to be tempted by private equity, hedge funds, bank-sold bonds or an extra ETF that skews your risk and allocation?

Most people don’t have that kind of mental strength.

But if you can harness the power to stay on course, years from now, you’ll be happy that you did.

You’ll also be the envy of almost everyone who caved.

Sources:

1. Berkshire Hathaway’s Munger On Private Equity, Investing; CNBC.
2. Influence, New and Expanded: The Power of Persuasion; Robert Cialdini, Harper Business 2021.
3. Madoff: The Man Who Stole $65 Billion; Erin Arvedlund, Penguin Books, 2009.
4. Warren Buffett: Private Equity Firms Are Typically Very Dishonest. Berkshire Hathaway Annual Meeting.
5. The Performance of Private Equity Funds; Oxford Academics Review of Financial Studies.
6. Berkshire Hathaway Chairman Letter, 2016.
7. HFRX Hedge Fund returns.