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

Warren Buffett is of course of study every bit the golden-touch investor who is chairman as well as CEO of Berkshire Hathaway. Each twelvemonth he writes a missive of the alphabet to his shareholders, as well as along amongst an update on exactly what the business solid did the previous year, he frequently discusses some broader point. In the finally distich 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 instruct the Great Recession inwards 2008 as well as 2009. But fifty-fifty those who were concerned most the economic scheme at that fourth dimension were non predicting that the stock marketplace seat would autumn past times one-half over the side past times side xviii months or so. But it is inwards Dec 2007 that Buffett made a bet that the average of the stock marketplace seat 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 storey inwards his 2016 letter:

"In Berkshire’s 2005 annual report, I argued that active investment administration past times professionals – inwards aggregate – would over a stream of years underperform the returns achieved past times rank amateurs who only sat still. I explained that the massive fees levied past times a diversity of “helpers” would leave of absence their clients – in i lawsuit 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 choose a laid of at to the lowest degree 5 hedge funds – wildly-popular as well as high-fee investing vehicles – that would over an extended stream tally the surgical operation of an unmanaged S&P-500 index fund charging alone token fees. I suggested a ten-year bet as well as named a low-cost Vanguard S&P fund every bit my contender. I hence sat dorsum as well as waited expectantly for a parade of fund managers – who could include their ain fund every bit i of the 5 – to come upwards forth as well as defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fearfulness putting a piddling of their ain coin on the line?

"What followed was the audio of silence. Though at that spot are thousands of professional person investment managers who bring amassed staggering fortunes past times touting their stock-selecting prowess, alone i human – Ted Seides – stepped upwards to my challenge. Ted was a co-manager of Protégé Partners, an property 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 as well as admire his willingness to position his coin where his oral cavity was. He has been both straight-forward amongst me as well as meticulous inwards supplying all the information that both he as well as I bring needed to monitor the bet.

"For Protégé Partners’ side of our ten-year bet, Ted picked 5 funds-of-funds whose results were to hold out averaged as well as 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 surgical operation of the funds-of-funds would non hold out distorted past times the goodness or piteous results of a unmarried manager. Each fund-of-funds, of course, operated amongst a layer of fees that sat higher upwards the fees charged past times the hedge funds inwards which it had invested. In this doubling-up arrangement, the larger fees were levied past times 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 alternative – a virtually cost-free investment inwards an unmanaged S&P 500 index fund – would, over time, deliver amend results than those achieved past times most investment professionals, withal well-regarded as well as incentivized those “helpers” may be." He writes:

"Addressing this interrogation is of enormous importance. American investors pay staggering sums annually to advisors, frequently incurring several layers of consequential costs. In the aggregate, produce these investors instruct their money’s worth? Indeed, in i lawsuit again inwards the aggregate, produce investors instruct 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 small-scale sample. Those 5 funds-of-funds inwards plough owned interests inwards to a greater extent than than 200 hedge funds.

"Essentially, Protégé, an advisory business solid that knew its agency exactly about 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 as well as confidence.

"The managers of the 5 funds-of-funds possessed a farther advantage: They could – as well as did – rearrange their portfolios of hedge funds during the 10 years, investing amongst novel “stars” spell 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 as well as the hedge-fund managers they selected significantly shared inwards gains, fifty-fifty those achieved only because the marketplace seat to a greater extent than frequently than non moves upwards. (In 100% of the 43 ten-year periods since nosotros took command of Berkshire, years amongst gains past times the S&P 500 exceeded loss years.)

"Those surgical operation incentives, it should hold out emphasized, were frosting on a huge as well as tasty cake: Even if the funds lost coin for their investors during the decade, their managers could grow real rich. That would occur because fixed fees averaging a staggering 21⁄2% of assets or hence were paid every twelvemonth past times the fund-of-funds’ investors, amongst purpose of these fees going to the managers at the 5 funds-of-funds as well as 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 amend inwards 2008, but every twelvemonth later that, they brutal 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 brutal in. In every i of the nine years that followed, the funds-of-funds every bit a whole trailed the index fund. Let me emphasize that at that spot was zip aberrational most stock-market conduct 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 bring probable averaged unopen to the 8.5% genuinely delivered past times the S&P 500. Making coin inwards that surroundings should bring 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 hit for the S&P index fund every bit 125.8%. For the 5 funds made upwards of hedge funds, the gains ranged from 2.4% to 87.7%.

Lessons? Outguessing the marketplace seat is hard, as well as most coin director don't succeed inwards doing it. Buffett writes:

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

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