Pitting Index Funds vs. Hedge Funds
We’ve all heard or read about Warren Buffett, the 86-year-old multibillionaire known for his friendly demeanor, modest style of living in Omaha, and remarkable ability to create wealth. But have you heard about his million-dollar bet made almost 10-years ago? It wasn’t a bet on a company or a
recent acquisition. He bet against the entire hedge fund industry.
Warren Buffett and The Bet
In 2005 Warren Buffett issued a challenge to the entire hedge fund industry: he could pick an S&P 500 Index fund that would outperform a hand-picked portfolio of hedge funds over a ten-year period. His reasons for making the bet were rooted in his belief that hedge funds charged fees that were way too high – too high to justify their performance. (Buffett staked his own money and not any money from his company - Berkshire Hathaway
Buffett’s 2016 Annual letter to the shareholders “In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still.
I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund.”
“Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?”
“What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds.”
“I hadn’t known Ted before our wager, but I like him and admire his willingness to put his money where his mouth was. He has been both straight-forward with me and meticulous in supplying all the data that both he and I have needed to monitor the bet.”
“For Protégé Partners’ side of our ten-year bet, Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager.”
So, beginning on January 1, 2008, the bet was made – Buffett selected his index fund – the Vanguard 500 Index Fund Admiral Shares and Protégé Partners made their selections. Performance was to be measured on a basis net of fees, costs and expenses.
As of February 2017, with 10 months left on the bet, Buffett is trouncing Protégé Partners and it appears all-but-certain that he will win.
As of the end of 2016 (nine years into the bet), the five funds-of-funds chosen by Protégé Partners delivered an average of 2.2%, compounded annually. The S&P index fund picked by Buffett has delivered an average of 7.1%.
Said another way, that means $1 million invested in the index fund would have gained $854,000 so far versus just $220,000 for the hedge funds. (See table below from Buffett’s annual shareholder letter.)
The Charity Wins
When the bet was established, both Buffett and Protégé Partners agreed that the winnings would go to charity: Girls Incorporated of Omaha if Buffett wins, Friends of Absolute Return for Kids if Protégé wins. But in an interesting turn, the money in the pot – which was supposed to safe and secure – has enjoyed fantastic returns – in fact, better than the returns from Buffett’s index fund and Protégé’s hedge funds.
Turns out that both sides originally invested the “bet” into zero-coupon Treasury bonds that were structured to rise to $1 million over 10 years. But when interest rates plunged, the bonds were up to nearly $1 million in 2014. So, both parties agreed to sell the bonds and buy shares of Buffett’s company – Berkshire B-shares.
The charities saw Berkshire-B increase by 26.64% in 2014, drop 12.06% in 2015, and increase 23.43% in 2016. But irrespective of what the Berkshire-B stock price does, the winning charity is guaranteed $1 million. And if the pot remains larger than originally agreed amount, the charity gets the surplus.
This led Buffett to an early victory speech this year when he said that there is “…no doubt that Girls Inc. of Omaha, the charitable beneficiary I designated to get any bet winnings I earned, will be the organization eagerly opening the mail next January.”
The bottom line is...fees matter.
Paul R. Rossi, CFA