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Would You Bet Against Warren Buffet?

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Hedge Funds bet against Warren BuffetWould you bet against Warren Buffet? At the 2006 Berkshire Hathaway annual meeting, Warren Buffet offered to bet $1 million that hedge funds couldn’t outperform the simple S&P index fund over a 10 year period. A few guys from the hedge fund world heard about this and they figured Buffet was wrong. They’d bet on hedge funds and the million dollar bet was born. Here are the terms on Long 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.”

Buffet’s Bet

Warren Buffet’s position is simple. He thinks that hedge funds charge too much fee and investors should stick with low fee index funds. Hedge funds typically charge 2% annual fee + 20% on any profit. In contrast, VFIAX (Buffet’s pick) charges only 0.05% in annual fees. VFIAX is Vanguard’s admiral class S&P 500 index fund. Admiral class funds have lower fees, but the minimum investment is higher than investor class funds (typically $10,000 vs $3,000).

Let’s do a quick comparison. If you invest a million dollars and gain 10%, how much fees would you pay in one year?

  • Hedge fund: $40,000 in fees
  • VFIAX: $550 in fees

Yowza! The big fee is a HUGE drag on your portfolio. The hedge funds would have to outperform the S&P 500 fund by at least 50% every year to win this bet.

The Other Side

On the other side is Protégé Partners, a hedge fund based in New York. They picked a basket of 5 undisclosed hedge funds. I don’t know much about hedge funds so I did a little research for this article. According to Investopedia, hedge funds are alternative investments that use a number of different strategies in order to earn active returns (alpha as they call it in the business.) You can read about the different strategies hedge funds use to beat the market at Investopedia. They can buy undervalued stocks, short overvalued stocks, get a discount on distressed securities, quantitative trading, invest in emerging markets, or whatever they want. Basically, hedge funds aim to generate gains in any market condition and reduce the risk to the investors.

Hedge fund managers are a collection of the most brilliant people ever produced. They have cutting edge technologies, the latest market information, and they are completely focused on making money. They know a lot more than regular investors so they should be able to beat the index fund handily, right?

The Result So Far

Apparently not. Hedge funds have had a string of bad years recently. There is less than 2 years left on the bet and Warren Buffet’s choice is way ahead. At the end of 2015, VFIAX is up 66% against 22%, for the hedge funds. The US stock market had been on a tear over the last 7 years and it was hard to beat the S&P 500 index funds. The lead looks insurmountable at this point, but you never know how the market will act. If we see a severe market crash, the hedge funds might make a comeback.

Beating The Index

So does that mean the hedge funds can’t beat the simple index funds? Not necessarily. The real winner of this bet would be the recipient of the $1 million donation (Buffet’s choice is Girls Inc. of Omaha). Each side put up $320,000 in a zero-coupon Treasury bond that will be worth $1 million at the end of 2018. However, at the end of 2012, the bond had risen over 50% to $950,000. They decided to cash in the bond and invest the proceeds in Berkshire Hathaway stock for the rest of the time. The pot has grown to $1.68 million by the end of 2014 and this has handily beaten the S&P 500 funds. See, it is possible to beat the market.

The best hedge funds are much better than the average hedge funds and they have beaten the market handily. Jim Simons’ Medallion Fund averaged 35% annual gain (after fee) since they started in 1993. George Soros’ Quantum fund generated an average annual return of over 30% while he was at the helm. Clearly, some hedge fund managers are worth the price they charge.

Would you bet against Warren Buffet?

The conclusion is some hedge funds really can beat the market over the long haul. However, the regular investors don’t have access to those top hedge funds. All the best performing hedge funds are closed and do not accept any new money. The rest of the classes can’t beat the market consistently and you’ll pay through the nose to invest in them. The next George Soros might head a small hedge fund in your city, but how can you pick him out?

For individual investors like you and me, it’s probably best to stick with the simple low cost index funds. That’s what we’re doing with our retirement accounts. If you can invest in one of the top hedge funds, then I’d say go for it. I wouldn’t bet on Protégé funds, though.

Do you invest in hedge funds? How did you do over the last few years?

Here is a great podcast at NPR’s Planet Money about this – Brilliant vs Boring.

Image by lionel.roubeyrie

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{ 31 comments… add one }

  • PhysicianOnFIRE March 23, 2016, 3:53 am

    Thanks for doing the research, Joe. Very timely. I just read about this bet yesterday in John Bogle’s “Enough” from 2008, when it was a fairly young bet.

    I told myself I need to look this up. Then I didn’t. But you did! Nice work. I believe the bet was $1 million plus earnings, although the link didn’t mention the earnings. Girls Inc. in Omaha is going to be in pretty good shape.

    • retirebyforty March 23, 2016, 10:51 am

      The comments at Long Bets are pretty interesting. A lot of people thought hedge funds would win. They pull way ahead in the first year, but then falter after that.

  • Dividend Growth Investor March 23, 2016, 5:41 am

    It is very interesting that these highly paid hedge fund managers have done so poorly. Those fees are a big drag on returns. On the other hand, if the stock market goes down in two years, the hedge funds might not look so bad.

    On the other hand, Buffett did run a “hedge fund like” partnership between 1956 – 1969. He charged investors 25% of the profits above a 6% hurdle rate. This is how he made his first $20 million by the way.

    Let’s look at this bet in 2 years, and see how it goes

    DGI

    • Mr. Tako @ Mr. Tako Escapes March 23, 2016, 8:58 am

      Yeah, I definitely wouldn’t bet against Buffet with those kinds of fees. They’ll definitely eat up a lot of the return. That doesn’t explain all of the underperformance though.

      Hedge funds can and do outperform the general market for long periods of time. Dan Loeb and Joel Greenblatt come to mind, in addition to those cited in the article.

      The irony here is that the man who’s beaten the market for *50 years* is now saying that a basket of hedge funds can’t do it…and he continues to run a ‘hedge fund’ within Berkshire Hathaway.

    • retirebyforty March 23, 2016, 10:53 am

      The hedge funds didn’t even do that well in 2008 with the financial meltdown. Protege’s picks beat the index, but still decreased over 20%. The top hedge funds are just so much better than the average hedge funds. I’m rooting for Warren Buffet.

  • Stefanie OConnell March 23, 2016, 5:48 am

    Just listened to great podcast episode on this – I think it was Planet Money. Made me feel vindicated in my index fund investment strategy.

    • retirebyforty March 23, 2016, 10:54 am

      Thanks for the reminder. I added the link at the end of the article. Index funds is just so much easier for regular investors.

  • Allan Liwanag March 23, 2016, 6:12 am

    This is a wonderful basic insight to the world of hedge funds. It’s so stunning how these hedge funds are doing so poorly in recent years while the fund managers still rake millions of dollars every year.

    I wish I had the money to investment in these hedge funds. But, then again, I may not think of investing in hedge funds if or when I have money. Thinking about the % they take from the profit makes me crawl. That’s a big chunk.

    As with the question of betting against Warren Buffet, my answer is a simple No.

    • retirebyforty March 23, 2016, 10:56 am

      Yeap, the hedge funds managers rake it in. They charge way too much and can’t even beat the index. It’s ridiculous. I’d pay those fees if they can perform like the best hedge funds, but the average hedge funds are just crap.

  • Dave in Sunny FL March 23, 2016, 7:24 am

    The much better alternative to betting for or against Warren Buffett, is to bet ON Warren Buffett. We have done that by investing in Berkshire-Hathaway stock. If you have a long-term investing horizon, there is no better mutual fund-type basket of investments available. Berkshire includes everything from candy and carpets, to real estate, car sales, and precision manufacturing. BRK includes chunks of American Express, Coca-Cola, and IBM; as well as wholly-owned subsidiaries GEICO and BNSF railroad. The company is adding on additional purchases all the time, buying additional companies that mesh well with existing operations (“bolt-on acquisitions”). There are literally hundreds of companies under their umbrella. Buffett expects the money to continue to flow so strongly, that payment of a dividend within a generation is inevitable. My advice would be, stop looking at those stock newsletters and Internet articles promising you “the next Warren Buffett.” Instead, invest in the real thing.

    • retirebyforty March 23, 2016, 10:58 am

      I agree. BRK.B is a great investment. I had a few shares, but sold it when the price went up. I should pick up a few shares again and just hold it.

      • John April 3, 2016, 8:06 pm

        I’m holding Berkshire Hathaway for the long term. I view it as somewhat of a quality version of an index fund.

  • Justin March 23, 2016, 8:01 am

    No way would I bet against WB! 🙂

    I’ve been following his anti-hedge fund bet (really an anti-fee bet) since it started back in 2008. So far so good, and I don’t see how hedge funds can overcome the SP500 at this point.

    I’m very fond of WB’s advice. I know he’s said in the past if you can’t invest like he does then you are best off as an individual investor to simply buy low cost passive index funds like what Vanguard offers. I’m firmly in the index fund camp and love paying under 0.20% to have broad global diversification.

    • retirebyforty March 23, 2016, 11:00 am

      I don’t see how the hedge funds can overcome the index fund either. If they’re great funds, then it’s possible. However, those funds didn’t perform very well over the last 8 years and I doubt that will change in 2 years. Protege should have put money on the top hedge funds like Medallion. I guess they can’t pick closed funds.

  • Jo March 23, 2016, 9:06 am

    I like WB approach because of a good reason: I’m invested in BRK-B and it is my best investment for the last ten years, even better than my SP500 investment and much better than my hedge fund investment.

    • retirebyforty March 23, 2016, 11:03 am

      You can’t go wrong with BRK.B. Warren Buffet has a great track record and anyone can buy the stock. It is a great investment.

  • freebird March 23, 2016, 9:51 am

    I’ve never invested in hedge funds but I still prefer individual company shares over mutual funds. I don’t think I’ve ever bought an ETF or an equity index fund outside of my 401ks. I keep a trading account that I funded in 1998 with one year’s gross pay and sealed at that year’s end. Nothing in or out, all fees and commissions paid inside of it, and all income taxes paid separately outside of it.

    According to Yahoo Finance Historical Prices ^GSPC S&P500 Adj Close* was 1280 on Jan 1 1999 and is 2040 today. If we assume an additional +3% annual dividends, that would be a 6% CAGR not adjusted for inflation. By comparison my trading portfolio’s market value multiplied almost exactly seven-fold during this time interval, or about 12% CAGR. Its rise since Jan 1 2008 was 49% vs your VFIAX up 66%, so I’m sucking wind on the back nine, maybe I’m getting too old for this game?

    Anyway that’s my plan for ER going forward, since apparently Simons and Soros are unavailable to me, I’ll be paying myself two and twenty per annum once my W2s stop.

    • retirebyforty March 23, 2016, 11:05 am

      Wow, great return in your portfolio. Maybe you took on more risk when you were younger?
      I wonder if you can setup a hedge fund for yourself and pay less tax somehow. 🙂
      I like your idea of paying yourself. Maybe we’ll do the same thing when Mrs. RB40 retires. 2+20% is a good amount.

  • JasonInVancouver March 23, 2016, 10:33 am

    Interesting topic Joe, that illustrates a number of core concepts.
    Fees matter and can have a significant impact on your nest egg over extended periods.
    Aspiring to being average (matching the index) can turn out better than actively trying to be the best every single year.
    The thing with hedge funds is that they invest in a wider range of investments and use a wider range of techniques that most people don’t understand and therefore don’t/can’t use. This isn’t necessarily a bad thing but makes it more difficult for investors of hedge funds to truly understand what they are investing in and understand the risks.

  • Brian - Rental Mindset March 23, 2016, 10:54 am

    “Clearly, some hedge fund managers are worth the price they charge.”

    Unless they got lucky over a set number of years. This is Buffett’s analogy of a national coin-flipping contest. After 20 rounds, a few people are going to look like they have a real talent: http://www.tilsonfunds.com/superinvestors.html

    • retirebyforty March 23, 2016, 11:05 pm

      Thank you for the link. That’s an interesting read.

  • FI Fighter March 23, 2016, 11:35 am

    VFINX and later VFIAX were in my retirement accounts from the time I was in college all the way up until the middle of 2015. That index fund has done phenomenal over the last 7 or so years, and one of the best investment decisions I ever made was to ride that wave up.

    But right now, I think there’s way more risk than any remaining reward left to extract from this fund. Corporate earnings and revenues are declining, growth is slowing globally, and the overall markets just aren’t cheap right now. Not saying this fund won’t do extremely well over the long-term, but right now I much prefer to be in cash.

    GLTA!

  • Midwestern Landlord March 23, 2016, 11:54 am

    I would bet against him but not in stocks. That is his game. I know off topic but I think the best opportunities for the “little guy” is real estate investing.

    Everyone knows the benefits (cash flow, appreciation, leverage, control, tax advantages, etc.)

    Said that I get it that not everyone wants to be a landlord and it may be outside of the comfort zone for some investors.

  • Financialnirvanamama March 23, 2016, 12:39 pm

    I have never invested in a hedge fund- I imagine that if you had billions of dollars to manage, it would be hard to buy and sell all at once, for ex: it becomes harder and harder to liquidate when the price is right.
    As smart as they are with their algorithm trading, quants, models etc. – it is harder and harder to trade with that much money. That’s why you hear the small and professional traders earn over 100percent returns using their own accounts because they are small and have liquidity as their advantage.

    Not surprise that the index funds beat the hedge funds.

  • Mike H. March 23, 2016, 2:11 pm

    Haha that wasn’t quite an apples-to-apples bet. The S&P500 has a huge advantage in that VFIAX is not interested in mitigating downside risk. Hedge Funds are. An S&P500 strategy can be a lifetime strategy. Hedge Funds can’t – you as an investor need to know the timeframes attached to their investments and strategies. A hedge fund might own land in rural China with an eye toward the 2100s (some pension funds do), while the S&P500 is by and large focused on the next quarter.

    I might bet against Warren Buffet on an individual stock; he and his managers have been wrong before (I mean, I have too…). But on this particular issue, I can’t disagree with his logic: for the hedge funds to win over a sufficiently-long period of time, they’d have to massively outperform their benchmarks. If you expect the market to rise, active managers will start to fall behind.

  • Casey W March 24, 2016, 9:44 am

    Mike H made a great point that hedge funds try to mitigate risk and the sp500 does not, so hedge funds will pretty much always underperform in a bull market.

    Aside from that, Index funds are usually best. If you are obsessed with personal finance, you have a few interesting advantages as an individual investor. I think these are the biggest advantages we retail investors have over Wall Street:
    1. Trading fees. We only have to pay $5-10 for any trades. Wall Street has to pay a percentage fee which can be $100,000 easily.
    2. No management fees. We are doing our own management for free since it’s a hobby!
    3. No timing pressure to perform. Wall Street managers are under immense pressure to perform well every quarter so they might not be able to have long-term views or hold a stock for long if it is not performing well. We can stubbornly hold stocks for a loooooong time.

    I have some fun picking out some stocks and building a little portfolio, but the majority of my investments are in index funds, so no I wouldn’t completely bet against Buffett!

  • Alan March 24, 2016, 1:14 pm

    The question everyone seems to ask is can a managed fund (which includes hedge funds) beat the market? Everyone seems to be convinced THAT is the question, and it is not. The real question that people should be asking is can the herd beat the market? And the answer to that is NO.

    When all those studies came out that index funds typically beat managed funds, it was at a time with many managed funds. Can the herds beat the market? No. So people have that in their head as the only answer. But in the last 5 years, the “herd” has gone the opposite way into index funds. Now with the herd in index funds, it never has been a better time to invest in managed funds. Remember, following the herd will never get you ahead, and that is the only certainty.

    • Mike H. March 24, 2016, 2:00 pm

      I can agree with your premise: that it is mathematically impossible for everyone to beat the market. Exactly half of investors will get returns below the median 😉

      But I disagree that that means that actively managed funds are a good investment now. I don’t believe that anything fundamental has changed with hedge funds that makes them act like another asset class. Put simply, they are powered by human behavior and by their own risk mitigation strategies. (I will allow that if a ton of people start putting their money into hedge funds, it will most likely draw more bad hedge fund managers into the business as they chase a quick buck, but I don’t think that was what you were getting at, right?)

      Mr. Buffet’s underlying point is that market returns are good enough. Studies have shown that most people, even the ones invested in passive index funds, won’t achieve market returns. Why not? Human behavior: chasing returns, failed market timing strategies, and asset leakage. Since the mid-1980s, the S&P500 has averaged something like 10ish%, while the average individual investor has averaged something like 1.85ish%, nearly a full percentage point lower than INFLATION over that time period. That’s…scary. [source: DALBAR’s 2014 Quantitative Analysis of Investor Behavior].

  • Nick - TheMoneyMine April 7, 2016, 5:22 pm

    Betting against Buffett isn’t a very good idea, but this was really a double bet against Buffett and Jack Bogle.
    This is probably going to be one more example, if not the most visible, of how the easiest way to accumulate wealth is to invest in funds with low cost, not better than market performance.
    I didn’t know the initial bet was placed in a bond that went up 50%, that is pretty cool for Girls Inc!

  • BeSmartRich April 12, 2016, 8:14 am

    Who dares to do that? 🙂 Simple ETFs typically is a great idea regardless of their investment skill levels. Thanks for sharing!

    BSR

  • ZJ Thorne May 7, 2016, 9:01 pm

    While I understand hedge funds, I don’t understand them enough to trust my money with. Overeducated folks make even bigger errors than folks who are less over-confident.

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