In 2007, Warren Buffett made a $1,000,000 bet with the hedge fund manager Protege Partners that the S&P 500 would perform better than a hand-picked selection of hedge funds. This bet became emblematic of the battle between passive and active management.
It is now 2017, and the bet is almost over. Over the past 10 years, we have seen all types of markets, from the bear market of 2008-2009 to the long bull market over the past 7 years. Let’s see who is winning, and how the results apply to us ordinary investors.
Terms Of The Bet
This was the original bet, as posted on the Long Bets website:
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.
Protege Partners was permitted to select five hedge funds to compete against the S&P 500. But these weren’t just hedge funds, they were fund-of-funds. So the S&P 500 was competing against a portfolio of funds of hedge funds, or a fund-of-fund-of-funds. This fund-of-fund-of-funds actually contained over 100 individual hedge funds.
The identities of the individual hedge funds or fund-of-funds are not publicly known, but Warren Buffett has been able to view the returns of the hedge funds and can vouch for the accuracy of their reported results.
Results Of The Bet: 2008-2016
In Warren Buffett’s 2017 annual letter to shareholders, he updated readers to the current status of the bet, and the S&P 500 is handily beating the hedge funds. The S&P 500 has returned 7.1% annually from 2008-2016, while the hedge funds have only returned 2.2%.
But before Mr. Buffett gloats too much, it should be noted that Berkshire Hathaway, his holding company, has only returned 6.2% annually from 2008-2016. Even the Oracle of Omaha has underperformed the S&P 500 over the past 9 years.
Why Index Funds Won
The most obvious reason for the S&P 500 index fund’s outperformance is its lower fees. Hedge funds typically charge 2% of assets under management and 20% of profits. This is even higher than the typical 1% charged by traditional mutual funds. For this particular bet, fund-of-funds are selected, which charge an extra layer of fees. This is like your financial advisor charging 1% of assets under management for the opportunity to select mutual funds that charge another 1-2% of assets.
This difference is incredibly hard to overcome, even for the most skilled of investors. Warren Buffett knew this, and it explains why he was so confident in his belief that the S&P 500 could outperform the hedge funds.
What is incredible is that the S&P 500 didn’t even do that great over this time period. Of the 8 major asset classes tracked by Novel Investor, the S&P 500 was #4 of 8:
|Asset Class||Annualized Returns 2008-2016|
|Small Cap Stocks||8.1%|
|Large Cap Stocks||7.1%|
The hedge funds could have picked a portfolio of small caps, high-yield bonds, or REITs and beaten the S&P 500, before fees. Unfortunately, after they take their cut of fees, a hedge fund consisting of any single individual asset class could not have beaten the S&P 500 index fund. No one can argue that the S&P 500 did exceptionally well compared to its peers during this period. As Buffett noted in his 2017 annual letter, a return of 7.1% over a 9-year period would be considered average stock market returns for most investors.
Hedge Funds Chased Absolute Over Relative Returns
Hedge funds typically state in their prospectuses that they are chasing absolute, not relative returns. Their goal is to perform well in up, down, or sideways markets. Their goal is not to necessarily beat the S&P 500 or any other index. As Warren Buffett noted in his 2017 annual letter to shareholders, the index fund would perform well if economic conditions lead to a rising market, while the hedge funds would do well in a declining market because they often take short positions as well as long positions.
Indeed, up until 2011, the hedge funds were actually beating the S&P 500. It wasn’t until the market continued to rise from 2012-2016 that the S&P 500 really began to shine against the hedge funds. There has been a steady drumbeat of predictions over the past 5 years that the market has made a top and is overvalued. Hedge funds were probably betting on a decline which never came.
In any sort of bet, there is an element of luck involved. If the hedge funds got lucky, they could have beaten the S&P 500. I would estimate that the hedge funds probably would have beaten the S&P 500 approximately 15-20% of the time. If the hedge funds were strictly interested in maximizing their chance of winning the bet, they would have went to a casino and put all of their money on black, and if they won, put the rest of the money in the S&P 500. This would have given them a 50/50 chance of winning the bet. Of course, the hedge funds were trying their best to beat the market, so they were more diversified. This made their returns closer to the overall market return, which after fees caused them to lose the bet.
Takeaways For The Average Investor
Index Funds > Actively Managed Mutual Funds
While this bet is an anecdote, not an academic study, it shows that physicians and other ordinary investors should invest in a diversified portfolio of low-cost index funds. The fascinating thing is that Protege Partners did not even dispute this fact when initiating the bet. As they said in their original thesis arguiing that hedge funds would beat the S&P 500:
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.
What Protege Partners was hoping to prove was that hedge funds, with their ability to short investments and make absolute, not relative returns, could beat the S&P 500. In this bet, they have failed.
More Research Or A Smarter Fund Manager Does Not Equal More Return
As Warren Buffett beautifully said in his investment thesis that the S&P 500 would beat the hedge funds in the original bet:
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.
Hedge Funds or Mutual Funds Can Win In The Short-Run
My personal thesis as to why there has been such a massive flow of money into index funds in recent years is simply that the index funds are beating the hedge funds. When (not if) the market begins to decline, investors will begin to chase returns by putting their money in actively managed funds. But since we all expect the stock market to go up in the long-term, low-cost index funds are the place to be, in good markets and bad.
What do you think? Is active management dead? Or did the hedge funds just get unlucky over the past 9 years?