Warren Buffett made a USD 1 million bet with hedge fund manager Ted Seides of Protégé Partners that a low-cost SP 500 index fund would perform better than a group of Protégé’s hedge funds. Buffett’s index investment bet is so far ahead that Seides concedes the match, although it doesn’t officially end until December 31.
According to the New York Post, the 5 funds through the middle of this year have been only able to gain 2.2 percent a year since 2008, compared with more than 7 percent a year for the SP 500 — a huge difference.
That means Seides’ USD 1 million hedge fund investments have only earned USD 220,000 in the same period that Buffett’s low-fee investment gained USD 854,000. “For all intents and purposes, the game is over. I lost,” Seides wrote. The USD 1 million will go to a Buffett charity, Girls Inc. of Omaha.
The bet: Over a 10-year period commencing on January 1, 2008, the SP 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. At the time of the bet, only Buffett and the managers at Protégé know the names of the hedge funds.
Each side of the bet put up about USD 320,000, and the total was invested in zero-coupon bonds that at the contest’s end would be worth USD 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.
Mr. Buffett is correct in his assertion that, on average, active management in a narrowly defined universe like the SP 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.
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