One of my personal rules of investing… don’t bet against Warren Buffett.
In late 2007, Warren Buffett and hedge fund manager, Ted Seides of Protégé Partners, made the following bet:
“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs, and expenses.”
Yes – Buffett bet that the biggest and simplest index fund would outperform a pool of the most sophisticated and exclusive investment managers in the world.
Buffett’s main point was not that hedge fund managers are terrible investors or that it was the opportune time to be investing in the US stock market. Buffett’s concern was cost. When the bet was made, Buffett noted “These investors will incur far greater costs. Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation.”
Seides’ defended his side: “For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. 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.”
The stakes of the bet were real: one million dollars going to charity.
I’ve been tracking the bet since 2008, and the final results have been tallied. Over the ten-year period ending 2017, the S&P 500 gained an average of 7.1% while Protégé’s hedge funds gained only 2.2% (both net of fees). This means that for every dollar invested in both strategies, Buffett received more than four times in gains (due to compounding) than the hedge funds provided. Buffett won the bet and the race wasn’t even close.
There are some investment lessons here:
- Costs matter. Hedge funds typically charge “2 and 20” (a 2% management fee plus they receive 20% of any gains received). This means that 10% of gross returns result in about 6% in actual returns to the investor. With these fee structures, the investor in the average hedge fund manager has little chance to outperform lower cost strategies over longer timeframes.
- The S&P 500 makes a great core holding. The S&P 500 index is made up of the largest (and most successful) companies in the US. Surely, there will be winners and losers in these 500 stocks, but overall, they make a solid core holding. I’ve been an investor in S&P 500 index funds since I started to invest in the early ‘90s, and it remains one of the largest equity holdings in my client (and personal) portfolios.
- Stock investing requires discipline. This bet started at the beginning of the 2008 financial crisis. Over the first 15 months of the bet, the S&P 500 index dropped 50%! Jumping out at that time would have been a sure losing strategy. Investing in stocks requires a long-term mindset and diversification across different stock markets and in other strategies (alternatives and bonds) that smooth the bumps along the way.
- Buffet did not bet on active management. I found it interesting that Buffett did not select his own company, Berkshire Hathaway, for the wager. Buffett is the poster child for great stock pickers and active management, yet he chose an index fund for the wager – this shows his confidence in indexing as an investment strategy. As it turns out, Berkshire underperformed the S&P 500 by almost 1% a year over the same 10-year time period.
- Some people refuse to learn. Although Seides lost his bet convincingly, he (predictably) has not changed his stripes. When conceding the bet earlier this year, Seides added: "My guess is that doubling down on a bet with Warren Buffett for the next 10 years would hold greater-than-even odds of victory".
Warren Buffett reinforced some valuable investment lessons while providing $2.2 million to Girls Inc., an Omaha-based charity that works to inspire girls to be “strong, smart and bold.” What’s better than that?