Buffett’s Big Bet

Fortune senior editor Carol Loomis has had a special relationship with Berkshire Hathaway chief executive Warren Buffett for many years, both as a personal friend and as the editor of Mr. Buffett’s widely read annual letter to Berkshire stockholders. Among many contributions throughout a Fortune career spanning more than fifty years, Loomis has written numerous thought-provoking articles about Berkshire and Buffett.

Drawing on that special relationship, Loomis has revealed to Fortune readers the details of an intriguing bet placed earlier this year by Mr. Buffett that should be of interest to any investor contemplating a commitment to hedge funds.

Buffett has often warned of the potential wealth destruction associated with investment expenses. In a 1999 Fortune article, he pointed out that the long-run return to investors in corporate America cannot be higher than what corporate America earns on its assets and that efforts to earn higher returns by moving money from one business to another (“chair-changing,” in Mr. Buffett’s lingo) might be successful for some investors but can only penalize results for investors in aggregate. To illustrate this idea, Buffett suggested in Berkshire’s 2005 annual report that readers imagine a simplified world in which all American corporations are owned in perpetuity by a single family, the Gotrocks. Succumbing to the promises of various “helpers” from the financial industry, some family members attempt to outsmart their relatives by purchasing some of their shares in various businesses and selling certain others. Other “hyper-helpers” appear to assist in selecting the best helpers (for an additional fee, of course.) The net effect on the Gotrock family wealth can only be negative as the total earnings on American businesses are diminished by the helpers’ fees. Buffett argues that the total “chair-changing costs” are substantial, estimating that “the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business.”

Buffett revisited the issue in Berkshire’s 2006 annual report, turning his attention to the fees charged by the typical hedge fund. Referring to the “2-and-20” crowd, Buffett observed that “the inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these ‘hyper-helpers.’

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