When presenting the arguments for indexing to clients or prospects I often encounter the objection “what about Warren Buffett”. In fact Buffett has often advised prospective investors to invest in index funds. Such was the case at last week’s annual meeting of Berkshire Hataway. Where Jason Zweig of Money magazine reports, the following exchange took place.
Asked what's in store for the economy, Buffett said he doesn't have a clue and doesn't care.
"I haven't the faintest idea," he said. "We never talk about it, it never comes up in our board meetings or other discussions. We're not in that business [of economic forecasting], we don't know how to be in that business. If we knew where the economy was going, we'd do nothing but play the S&P futures market."
His simple point: As an investor, you don't need to predict the economic cycle (or even pay much attention to it). Instead, you should focus on evaluating individual businesses if you pick your own stocks -- or, simply buy the entire market in the form of an index fund. When a shareholder asked for the single best specific investment idea Buffett could recommend to an individual in his 30s, Buffett said: "I would just have it all in a very low-cost index fund from a reputable firm, maybe Vanguard. Unless I bought during a strong bull market, I would feel confident that I would outperform...and I could just go back and get on with my work."
Buffett also downplayed expectations that he would outperform the overall market going forward. It is also important to note that Berkshire Hathaway’s low funding costs (it basically takes in insurance premiums and invests them), attractive tax status for his insurance entity, heavy investment in privately held companies (which are not marked to market on a daily basis like a mutual fund’s holdings) make a direct comparison between Buffet’s results and those of an open end mutual fund impossible.
One more puzzling thing came out of this year’s annual report . Many indeed have called the Oracle of Omaha incredibly perceptive when he wrote this well before the current financial crisis.
I view derivatives as time bombs, both for the parties that deal in them and the economic system.
I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multimillion-dollar bonus or the CEO who wanted to report impressive 'earnings' (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.
Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade and eliminate bumps for individual participants. On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.
The derivatives genie is now well out of 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.
-- Warren Buffett's Letter to Investors, Berkshire Hathaway 2002 Annual Report
Yet here’s what came out of this year’s financial results:
May 3, 2008
Derivatives Hurt Profit at Berkshire Hathaway
By REUTERS
OMAHA (Reuters) — Berkshire Hathaway, Warren E. Buffett’s investment company, said on Friday that first-quarter profit tumbled 64 percent, hurt by $1.6 billion of pretax losses tied to derivatives contracts….
Net income fell to $940 million, or $607 a Class A share, from $2.6 billion, or $1,682, a year earlier….
The derivative losses stemmed from Berkshire’s exposure to contracts aimed at making money if junk bonds stayed out of default and stock indexes rose.
In February, Mr. Buffett revealed that Berkshire ended 2007 with $40 billion of exposure to 94 of these contracts.
Berkshire said it had a $1.2 billion unrealized loss on put options it wrote on the Standard & Poor’s 500-stock index and three foreign stock indexes. It also reported a $490 million unrealized loss on contracts that require payouts if some high-yield bonds default from now to 2013. Other contracts brought the net loss in derivatives down to $1.6 billion.
Accounting rules require the company to report unrealized gains and losses in earnings regularly, Berkshire said.
The exposure may at first seem odd given that, in his shareholder letter in 2003, Mr. Buffett called derivatives “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
But in his letter this year, Mr. Buffett said Berkshire had already been paid for its derivatives contracts, giving it cash to invest, and that “there is no counterparty risk.”
He also said shareholders should be prepared for gains and losses that could “easily” top $1 billion in a given quarter.
Curious, to put it mildly, it seems even the "rock solid" portfolios contain ticking time bombs
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