Will Warren Buffett win this bet?

Sep 18, 2014

Investing icon Warren Buffett made a bet about the relative performances of hedge funds and index funds, that the latter would beat the former  over a decade. 

The bet: Over a 10-year period commencing on January 1, 2008, 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.

The predictor: Warren Buffett

The challenger: Protégé Partners LLC, money managers based in New York.

The terms of the bet

The low-priced index fund that Buffett narrowed down on is the Vanguard 500 Index Admiral Shares. Only Buffett and the managers at Protégé know the names of the hedge funds.

Each side in the bet put up about $320,000, and the total was invested in zero-coupon bonds that at the contest’s end would be worth $1 million. The winner decides which charity it should go to.

Worth mentioning is that Buffett has made this bet on his own, not with Berkshire Hathaway’s money.

The arguments for either side

A lot of very smart people set out to do better than average in securities markets. Call them active investors.

Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.

Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.

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.

-        Warren Buffett

Mr. Buffett is correct in his assertion that, on average, active management in a narrowly defined universe like the S&P 500 is destined to underperform market indexes. That is a well-established fact in the context of traditional long-only investment management. But applying the same argument to hedge funds is a bit of an apples-to-oranges comparison.

Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional “relative-return” investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls. 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. We believe such results will continue.

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.

-        Protégé Partners

Who’s winning?

The hedge fund boys were off to an early lead.

One year into the bet, stocks plunged, and Vanguard 500 Index plummeted along with them. Although hedge fund of funds, or HFOFs, did not dodge the 2008 downturn as successfully as the technology-stock sell-off, their calendar-year loss was less than half that of the Vanguard 500 Index portfolio.

Scott Keller, an investment specialist at Truepoint Wealth Counsel, an advice business based in the US, gives an update. His views were originally published on the Morningstar US  and Australia websites.

Through early this year, the index fund was up 43.8% from when the bet started. Protégé's portfolio of hedge funds reported a gain of only some 12.5% after fees. There's the key.

Where Buffett's index fund charges a mere .05%, hedge funds typically charge a 2% management fee and also take 20% of the profits (hence the moniker "2 and 20").

When hedge-fund managers do generate above-market returns, they take 20% off the top rather than the investor reaping full benefit. From 1998 to 2010, in fact, the hedge-fund industry captured at least an estimated $379 billion in fees versus investors' gains of $70 billion.

Hedge funds tend to be illiquid, offer limited windows to withdraw invested money, receive a relative lack of oversight, and bear the additional costs of leverage and derivatives that vary with fluctuations in underlying assets. Only a few funds outperform the market averages.

Yet hedge funds continue to attract investors. A high percentage of the investing public -- with the encouragement of financial headlines -- eagerly buy into the hype, wanting to believe you can consistently achieve returns that beat the market.

Others find the exclusivity of hedge funds alluring and are willing to pay the premium to be part of a swanky, high-net-worth club of investors who meet the funds' standard of at least $1 million in investable net worth (excluding residence) and $200,000 in income.

Those who followed the hype surrounding hedge funds over the years, though, expected Buffet's low-priced fund to come out ahead because we understand the long-term lessons of the market -- glamorous marketing ploys leave us unswayed. The payoffs are uncertain, the expense ratios (maintenance fees) high and the lack of full disclosure prevalent.

As in much other investing, Buffett's position seems worth sticking to for building wealth with steady and solid growth.

In hindsight, what did Buffett see back then?

In an article titled Buffett’s bet on the huddled masses, Morningstar’s Vice President of Research John Rekenthaler explained that at the time, Buffett's decision appeared odd. Hedge funds were regarded as one of the ways that the rich became richer. Index funds, in contrast, were a sound way of investing in mutual funds--but they were only mutual funds. How good could they be if anybody could own them?

Indeed, hedge funds had thrashed the stock market over the previous 10 years. Hedge funds had profited nicely during the decade's seven feast years and had also finished in the black during the famine of 2000-02, when stocks were thrashed. Over that period, HFOFs had trailed hedge funds themselves because of the cost of their extra layer of fees, but they were still well ahead of the S&P 500. From 1998 through 2007, HFOFs had gained an average of 9% per year, with the S&P 500 at 6%. 

In hindsight, what Buffett saw back then:

1)      Hedge funds had changed for the worse.

Had the industry remained small and unknown, Buffett might well have refrained from the wager. However, with monies flowing into hedge funds pushing the industry's assets past the $2 trillion mark by the middle of last decade, hedge fund managers were in a bind. They could invest as they always had done, meaning that too much money would now be placed into too few trades. Or they could change by seeking less obviously profitable trades. Either way, they faced a problem.

2)      The cost advantage of the index fund remained intact.

With HFOF fees running north of 3% annually (and potentially far north of 3% because of performance fees), hedge fund managers would need to get a lot of things right to overcome the ongoing cost disadvantage. It is possible that they could overcome point number one and get those things right, even with the burden of their swollen asset bases. But possible is not how to bet, not when the offered odds are even.

Right now Buffett is in the lead. But let's wait and watch.

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