Warren Buffett has won his 10-year bet against a group of hedge funds. The story of the bet is not widely known despite coverage by the financial press, but it holds a valuable lesson for investors.
Here is the exact text of the 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.”
The first thing you may notice is that the bet ends on Dec. 31, 2017, and it is only July. That tells you how badly the hedge funds are losing. Through late 2016, the S&P had gained 71% while the hedge funds gained only 25%. Even nine months ago, John Rekenthaler of Morningstar concluded that the gap in performance was too large for even a correction of 2008 magnitude to overcome.
With the S&P having advanced about 17% since the presidential election, it would take a stock market correction of epic proportions for the hedge funds to win. In May 2017, the hedge fund manager, Ted Seides of Protégé Partners, conceded in a Bloomberg article that bet was over, “I lost.”
The story of the bet begins with the 2005 Berkshire Hathaway annual report in which Warren Buffett made the following claim: “active management by professionals—in aggregate—would over a period of years underperform the returns achieved by rank amateurs who simply sat still.” He further argued “that the massive fees levied by a variety of “helpers” would leave their clients—again in aggregate—worse off than if the amateurs simply invested in an unmanaged low-cost index fund.”
Buffett subsequently offered to bet $500,000 that no investment professional could select at least five hedge funds that would outperform the Vanguard S&P 500 Index over a 10-year period. Despite Buffett’s taunting that “these managers urged others to bet billions on their abilities,” only one manager, Ted Seides of Protégé Partners, stepped up to the challenge and put down his $500,000.
The only condition for the hedge fund side of the bet was that it includes at least five hedge funds. Ted Seides chose five “funds-of-funds,” which means that each fund invests in multiple hedge funds. All told, the hedge fund portfolio consisted of over 100 hedge funds.
Why did the hedge funds lose? Let’s first consider the explanations offered by the hedge fund manager in his Bloomberg concession. He offers six reasons, but they all circle back to the same point: they were unlucky. First, he argues that they should not have lost. With the market near an all-time high in January 2008—that is, with near historical highs in market prices—the odds were great that the S&P would underperform over the next 10 years. The fact that it did not makes the hedge fund managers unlucky but not wrong.
Second, “risk matters…eventually.” He argues that a passive investment in the S&P 500 is, in effect, a continuous bullish bet on the stock market, whereas hedge fund managers continuously balance returns against risk. The absence of any significant market correction since 2008 worked against the hedge funds. Over a longer period, he believes the hedge funds would prevail.
Third, the S&P 500 is not representative of a diversified, global stock market. It excludes international stocks and small company stocks. Seides argues that the outperformance of the S&P 500 over the 10 years measured was an anomaly.
Fourth, comparing hedge funds with the S&P 500 is like comparing apples and oranges. This statement builds on his first three explanations for losing, but it is a curious excuse to offer nearly 10 years after placing a $500,000 wager. Now he tells us.
Fifth, the outperformance of the S&P 500 was only one outcome among many possibilities. Its success was an improbable outcome.
Sixth, “long-term returns only matter if we invest for the long-term.” Investors who bail out of the market during severe corrections like 2008-09 will fail to realize the long-term returns of the market. He argues, “hedge-fund investors stood a much better change of staying the course and earning the returns on the rebound, even if those returns were less than those of an index fund.” This is an interesting point, but he offers no evidence that hedge fund investors were more disciplined and successful than index fund investors.
Ultimately, the hedge funds lost, he believes, because they were unlucky and not because they were wrong. There is an adage in business, however, that says, there are reasons, and then there are results. The hedge funds got crushed.
As for Buffett, he offers a simple reason for his success: costs. As Rekenthaler of Morningstar observed, “Buffett bet against costs.” The Vanguard S&P 500 Fund he chose has an annual expense ratio of less than .10%. The hedge funds cost, on average, over 3% annual.
Buffett’s explanation turns the hedge fund excuses on their head. The hedge fund manager says that they were simply unlucky with the market performance that materialized over the period of the bet. Perhaps, but Buffett knew in advance that with a 3% annual cost differential, the hedge funds would have to be unusually lucky to prevail.
The lesson for investors? Forget about luck. Cost matters more.
David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625, [email protected].