The Big Idea
We are big fans of Warren Buffett and all that he has achieved. This point should be kept in mind at all times as you read the content on this website. However, we feel that far too much of his success is attributed to his stock picking, rather than his use of the insurance and reinsurance businesses, which are the real drivers of his outsized success.
Buffett was a hedge fund manager for 13 years. He quit cold turkey to go into insurance, reinsurance, and banking, because he could deliver better returns if he managed the assets of an insurer, reinsurer, or bank than he could if he only managed assets for a fund. Later on, the government gave him the choice of exiting the insurance and reinsurance businesses or the bank and he sold Illinois National Bank, leaving insurance and reinsurance as his vehicles for outperformance.
In comparison to returns from a fund or managed account, an insurer, reinsurer, or bank enjoys two advantages. The first advantage is a form of leverage. In the case of insurers and reinsurers, Buffett calls this “float”. In the case of banks, we are referring to term deposits of greater than one year as opposed to demand deposits that are used for paying bills and accessing ATM machines.
The differences between float or term deposits and leverage are significant. In an operating company, leverage is converted to assets such as plant and equipment, inventories, and receivables that may not be liquid enough to repay the leverage when it is due. In the case of financial assets, leverage usually means a demand loan or deposit, the terms and availability of which can change on a moment’s notice.
Buffett goes to great lengths to disparage leverage and distinguish it from float. Float and term deposits are stable in cost and duration, relatively predictable, and do not require disorderly liquidations of assets to meet an obligation.
In the case of insurers and reinsurers, the industry wide cost of float is roughly 3% per year. To the extent that the insurer or reinsurer invests the float at a higher rate of return than its cost, it earns a spread (similar to the spread that a bank earns if its interest income, net of loan losses and operating expenses, exceeds its deposit costs). Thus pre-tax ROEs are a function of the investment returns on the equity capital plus the number of turns of leverage times the spread per turn.
Buffett has always used a moderate level of float. In the early days, Berkshire used roughly $2 of float for $1 of equity capital. Today, Berkshire uses about 60 cents of float for each $1 of equity capital. By comparison, Swiss Re is levered 6 times and Generali’s leverage to tangible book value is 40 times.
One of the great myths about Buffett is that he has always gotten float for less than nothing (in other words he is paid for holding the float). Until he bought Geico, Buffett never consistently achieved a negative cost of float and until 2006 (the year after Katrina), he never cumulatively had a negative cost of float. For nearly 40 years, Berkshire’s cumulative cost of float was roughly 2.2% per year (still better than the average), but he invested the proceeds at rates of return much higher than 2.2% per year.
The second advantage of Structural Alpha is a premium to book value if the insurer, reinsurer, or bank is publicly traded. At the end of 2013, Berkshire and Third Point Re traded at 1.4 times book value on the New York Stock Exchange and Greenlight Capital Re traded at 1.3 times book value. By comparison, a closed ended fund is virtually certain to trade at a discount to NAV.
If an asset manager invests the equity capital of an insurer, reinsurer, or bank as he or she would a fund or managed account, and the financial institution breaks even operationally, the financial institution and the fund would have identical pre-tax returns.
However, to the extent that assets earn more than the cost of float or deposits plus operating expenses, the pre-tax ROEs for the financial institution will be higher than those of the fund. Compounding higher ROEs and applying a premium to book if publicly traded accelerates the level of outperformance. Since neither the financial institution nor its shareholders are taxed annually on its earnings this difference is even greater for investors who are annually taxable on investment income and realized gains.
We call the Big Idea of using an insurer, reinsurer, or bank to deliver asset management skills “Structural Alpha”.
Aside from Buffett, more than 40 asset managers have either acquired or started insurers, reinsurers, or banks, where they manage all of the assets of the institution and usually do so for full fees. Some of the better known asset managers who have done this include:
We believe that we have advised more asset managers who have successfully launched or acquired an insurer, reinsurer, or bank in order to manage its assets than all the other asset managers combined who have successfully launched or acquired an insurer, reinsurer, or bank without our advice. Only one of our insurers, reinsurers, or banks has ever underperformed the manager’s funds and that manager had lost money as an asset manager (leverage works both ways).
As such, we also believe that any asset manager who can deliver pre-tax returns in excess of 5% per year over any 5 year rolling period of time can replicate the Buffett model and outperform his or her funds or managed accounts with a high degree of certainty.
Those who are interested learning more about this Big Idea may download or link to the following:
1. A Tale of Two Capital Structures – Our 2010 paper on Structural Alpha
Download the pdf file
2. Floats and Moats – Professor Sanjay Bakshi’s presentation on Buffett’s success
3. Opalesque TV on Structural Alpha
Furthermore, the following pieces tracking the transition of Buffett from hedge fund manager to master of Structural Alpha are available upon request:
1. Carol Loomis on Hedge Funds (1966) –
Buffett’s letter editor calls him a hedge fund manager
2. Carol Loomis on Hedge Funds (1970) –
She again refers to Buffett as a hedge fund manager
3. Buffett’s Alpha – AQR’s 2012 paper on Buffett
4. The Economist’s Review of AQR’s paper on Buffett’s Alpha
5. Buffett’s Secret Sauce – Forbes.com weighs in
6. Buffett on the Advantages of Float – In his own words