Index Funds Vs. Hedge Funds: Buffett's Bet, X Years Later

Warren Buffett is of class equally the golden-touch investor who is chairman in addition to CEO of Berkshire Hathaway. Each yr he writes a missive of the alphabet to his shareholders, in addition to along amongst an update on exactly what the theatre did the previous year, he oftentimes discusses some broader point. In the lastly brace of years, Buffett's annual missive of the alphabet has harked dorsum to a revealing bet he made 10 years inwards Dec 2007.

Just to laid the stage, Dec 2007 is the leading border of what would larn the Great Recession inwards 2008 in addition to 2009. But fifty-fifty those who were concerned almost the economic scheme at that fourth dimension were non predicting that the stock marketplace would autumn yesteryear one-half over the side yesteryear side xviii months or so. But it is inwards Dec 2007 that Buffett made a bet that the average of the stock marketplace over the next 10 years would outperform the hedge funds that were using fancy investment strategies--and charging high fees. Here's how Buffett tells the even out inwards his 2016 letter:

"In Berkshire’s 2005 annual report, I argued that active investment management yesteryear professionals – inwards aggregate – would over a catamenia of years underperform the returns achieved yesteryear rank amateurs who only sat still. I explained that the massive fees levied yesteryear a diversity of “helpers” would leave of absence their clients – in 1 trial again inwards aggregate – worse off than if the amateurs only invested inwards an unmanaged low-cost index fund. ...

"Subsequently, I publicly offered to wager $500,000 that no investment pro could take away a laid of at to the lowest degree 5 hedge funds – wildly-popular in addition to high-fee investing vehicles – that would over an extended catamenia tally the functioning of an unmanaged S&P-500 index fund charging entirely token fees. I suggested a ten-year bet in addition to named a low-cost Vanguard S&P fund equally my contender. I in addition to then sat dorsum in addition to waited expectantly for a parade of fund managers – who could include their ain fund equally 1 of the 5 – to come upwards forth in addition to defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fright putting a petty of their ain coin on the line?

"What followed was the audio of silence. Though at that topographic point are thousands of professional person investment managers who convey amassed staggering fortunes yesteryear touting their stock-selecting prowess, entirely 1 human being – Ted Seides – stepped upwards to my challenge. Ted was a co-manager of Protégé Partners, an property managing director that had raised coin from express partners to shape a fund-of-funds – inwards other words, a fund that invests inwards multiple hedge funds.

"I hadn’t known Ted earlier our wager, but I similar him in addition to admire his willingness to seat his coin where his oral cavity was. He has been both straight-forward amongst me in addition to meticulous inwards supplying all the information that both he in addition to I convey needed to monitor the bet.

"For Protégé Partners’ side of our ten-year bet, Ted picked 5 funds-of-funds whose results were to live averaged in addition to compared against my Vanguard S&P index fund. The 5 he selected had invested their coin inwards to a greater extent than than 100 hedge funds, which meant that the overall functioning of the funds-of-funds would non live distorted yesteryear the goodness or pathetic results of a unmarried manager. Each fund-of-funds, of course, operated amongst a layer of fees that sat higher upwards the fees charged yesteryear the hedge funds inwards which it had invested. In this doubling-up arrangement, the larger fees were levied yesteryear the underlying hedge funds; each of the fund-of-funds imposed an additional fee for its presumed skills inwards selecting hedge-fund managers. ..."

For the record, the winner of the bet would donate all gains to charity--in Buffett's case, Girls Inc. of Omaha. As he described in the 2017 letter (dated Feb 24, 2018), Buffett made the bet "to publicize my conviction that my selection – a virtually cost-free investment inwards an unmanaged S&P 500 index fund – would, over time, deliver improve results than those achieved yesteryear most investment professionals, even thence well-regarded in addition to incentivized those “helpers” may be." He writes:

"Addressing this enquiry is of enormous importance. American investors pay staggering sums annually to advisors, oftentimes incurring several layers of consequential costs. In the aggregate, create these investors larn their money’s worth? Indeed, in 1 trial again inwards the aggregate, create investors larn anything for their outlays?

"Protégé Partners, my counterparty to the bet, picked 5 “funds-of-funds” that it expected to overperform the S&P 500. That was non a modest sample. Those 5 funds-of-funds inwards plough owned interests inwards to a greater extent than than 200 hedge funds.

"Essentially, Protégé, an advisory theatre that knew its means or thence Wall Street, selected 5 investment experts who, inwards turn, employed several hundred other investment experts, each managing his or her ain hedge fund. This assemblage was an elite crew, loaded amongst brains, adrenaline in addition to confidence.

"The managers of the 5 funds-of-funds possessed a farther advantage: They could – in addition to did – rearrange their portfolios of hedge funds during the 10 years, investing amongst novel “stars” field exiting their positions inwards hedge funds whose managers had lost their touch.

"Every instrumentalist on Protégé’s side was highly incentivized: Both the fund-of-funds managers in addition to the hedge-fund managers they selected significantly shared inwards gains, fifty-fifty those achieved only because the marketplace to a greater extent than oftentimes than non moves upwards. (In 100% of the 43 ten-year periods since nosotros took command of Berkshire, years amongst gains yesteryear the S&P 500 exceeded loss years.)

"Those functioning incentives, it should live emphasized, were frosting on a huge in addition to tasty cake: Even if the funds lost coin for their investors during the decade, their managers could grow really rich. That would occur because fixed fees averaging a staggering 21⁄2% of assets or thence were paid every yr yesteryear the fund-of-funds’ investors, amongst business office of these fees going to the managers at the 5 funds-of-funds in addition to the residuum going to the 200-plus managers of the underlying hedge funds."

Here is a tabular array showing the results. The hedge funds did improve inwards 2008, but every yr afterward that, they roughshod farther behind. Buffett writes:

"The 5 funds-of-funds got off to a fast start, each beating the index fund inwards 2008. Then the roof roughshod in. In every 1 of the ix years that followed, the funds-of-funds equally a whole trailed the index fund. Let me emphasize that at that topographic point was aught aberrational almost stock-market demeanor over the ten-year stretch. If a poll of investment “experts” had been asked belatedly inwards 2007 for a forecast of long-term common-stock returns, their guesses would convey probable averaged unopen to the 8.5% genuinely delivered yesteryear the S&P 500. Making coin inwards that environs should convey been easy. Indeed, Wall Street “helpers” earned staggering sums. While this grouping prospered, however, many of their investors experienced a lost decade."

Over the 10 years, the full arrive at for the S&P index fund equally 125.8%. For the 5 funds made upwards of hedge funds, the gains ranged from 2.4% to 87.7%.

Lessons? Outguessing the marketplace is hard, in addition to most coin managing director don't succeed inwards doing it. Buffett writes:

"Performance comes, functioning goes. Fees never falter. ... Influenza A virus subtype H5N1 lastly lesson from our bet: Stick amongst big, “easy” decisions in addition to eschew activity. During the ten-year bet, the 200-plus hedge-fund managers that were involved almost for sure made tens of thousands of purchase in addition to sell decisions. Most of those managers undoubtedly idea difficult almost their decisions, each of which they believed would attempt out advantageous. In the procedure of investing, they studied 10-Ks, interviewed managements, read merchandise journals in addition to conferred amongst Wall Street analysts."

Berkshire Hathaway keeps an online archive of Buffett's annual letters dorsum to 1977. For a brace of previous posts based on Buffett's annual letter, see: