Buffett’s Big Bet

Surely trusting your money to sophisticated hedge fund managers must be a more lucrative investment strategy than the much cheaper option of investing in a simple index tracker fund?  Not according to the world’s most famous investor, Warren Buffett.

In Berkshire Hathaway’s 2005 annual report, Buffett argued that active investment management by professionals must, in aggregate, underperform the returns achieved by rank amateurs who “simply sat still” (that is, passive investors in index funds). The main reason he gave was the “massive fees” levied by those professionals. Buffett subsequently offered to wager $500,000 that no investment pro could select a set of at least five hedge funds that would, over an extended period, match the performance of an unmanaged index fund that charges only token fees.

You’d think the pros would be lining up to take Buffett on. After all, these ‘masters of the universe’ (as the financial press is wont to call them) had no problem touting their investment abilities to their clients (and earning huge fees every year). Surely they would be happy to put a little of their money where their mouths were.

Apparently not. For a long time, nobody came forward to take the other side of the bet. When Buffett eventually repeated his offer, one man  – a New York fund manager named Ted Seides – stepped up. Buffett chose a S&P500 index fund run by Vanguard. Seides chose five hedge funds, one of which was managed by his own firm, Protégé Partners LLC.

The terms were agreed by both sides and the measurement period of the bet commenced on 1st January 2008. It is due to expire at the end of this year – 31st December 2017. Many people (including me) were, therefore, expecting Buffett to write about his victory in next year’s annual letter to shareholders, which is released each February.

Few people expected Buffett to write about it in this year’s letter – before the bet expired – but that’s exactly what happened. Why? Because the index fund’s lead over the hedge funds was so great that Buffett knew it simply couldn’t be caught by the end of the 10 year period. Seides himself officially threw in the towel shortly afterwards, and Buffett’s chosen charity – Girls Inc. of Omaha, Nebraska (his home town) will be over $1 million better off.

So just how badly did the hedge funds fare over nine years? Well, the index fund delivered a respectable +85.4% – roughly in line with normal expectations for such a time period. Not one of the hedge funds beat that figure, or even got close. The best was a mediocre +62.8%, the next best a dismal +28.3%. All of the other three delivered less than +10%. In nine years! These are appalling results by almost any measure.

The thing that strikes me most about this whole story is the confidence with which Seides originally made his argument, in direct opposition to the man widely regarded as the best investor we have ever seen. In essence, Buffett’s argument was “the huge costs involved with active management are almost impossible to overcome”. Seides’ argument was essentially “yeah, but if you know what you’re doing…”. Yet he didn’t even get close to the simple index fund.

The full arguments can be seen on the LongBets website, here: http://longbets.org/362/

In 2007, when the bet was originally agreed, Seides’ Protégé Partners firm was managing $billions of other people’s money. Which goes to show – when it comes to investing, it’s far easier to convince others you know what you’re doing, than to actually know what you’re doing!

Phil Miller – Head of Client Services, Marland Thomas
21 November 2017

 

The information in this article is necessarily of a general nature. It does not represent either legal advice or financial advice. Specific advice should be sought for specific situations.