The Million Dollar Bet
At Berkshire Hathaway’s 2006 annual company meeting, Warren Buffet was on stage talking when the subject of hedge funds came up. Buffet said that hedge funds are not worth the fees they charge investors and he would be willing to bet he could pick an investment that would beat hedge funds. He offered to bet any taker, $1 million that over ten years and after fees, the performance of an S&P 500 index fund would beat ten hedge funds that any opponent might choose.
Buffet’s offer did not fall on deaf ears. In July 2007, Ted Seides of Protege Partners reached out to Buffet to negotiate terms of the wager. Buffet would take a Vanguard S&P 500 index fund, Protege would select a portfolio of five hedge funds. The $1 million would go to a charity of the winner’s choice.
Opening arguments for Buffet and Protege were published on the website longbets.org. Buffet says:
“A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.”
Protege conceded that Buffet is correct in his assertion that active management in a narrowly defined universe is destined to underperform an index. They argue however, that hedge funds do not set out to “beat the market”, they seek to generate positive returns over time regardless of the market environment.
The contest started on January 1, 2008. Buffet’s timing could not have been worse.
By early 2009, in the throws of the financial crisis, the S&P 500 had tumbled nearly 45%. The funds selected by Protege didn’t fare well either (~-25%), but had performed substantially better than the index. Seides had chopped one of Buffet’s legs off early and now just had to lean on him until he fell over.
We’re now more than eight years into the bet. How’s Buffet doing? Well his S&P 500 index fund is up 66% versus Protege’s collection of hedge funds returning just 22%. With only two years left, Buffet’s lead is virtually insurmountable.
In Protege’s argument for hedge funds they said the following:
“There is a wide gap between the returns of the best hedge funds and the average ones. This differential affords sophisticated institutional investors, among them funds of funds, an opportunity to pick strategies and managers that these investors think will outperform the averages. Funds of funds with the ability to sort the wheat from the chaff will earn returns that amply compensate for the extra layer of fees their clients pay.”
They are essentially saying, the best hedge funds are worth the fees. That’s fair. Some hedge funds do extraordinarily well for their investors. The problem however, is selecting those hedge funds ahead of time. Picking good hedge funds is as challenging as picking good stocks. In aggregate, when costs are considered, it’s a loser’s game.
“[Indexing] is the essence of bordem. If you’re in investing for excitement, your’e a damn fool. You’re watching the market every day, up and down. 100 points, 200, 300, 400 point swings day after day. It’s exciting, but it’s meaningless.” – Jack Bogle
If you still insist on playing the game, there is only one active fund I can think of that has preformed extremely well over the past fifty years, does not charge a fee and is accessible to all investors…Warren Buffet’s own, Berkshire Hathaway.
There is one final caveat I’ll provide for consideration…
Knowing that his time left on this planet is limited, what advice is Buffet giving to his survivors, the people he cares about the most?
“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”
Update: How did hedge funds do in 2015? Well out of the thousands of hedge funds in existence, the top 20 returned about $15 billion to their investors. The rest of the industry lost $99 billion. Good luck!
Source: LCH Investments