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

Lower Fees

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 ClassAnnualized Returns 2008-2016
Small Cap Stocks8.1%
High-Yield Bonds7.9%
REIT7.7%
Large Cap Stocks7.1%
High-Grade Bonds4.1%
Cash0.3%
International Stocks0.1%
Emerging Markets-1.3%

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.

Luck

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?

8 COMMENTS

  1. I believe index funds are superior except where your the actual management of a business. I.e. Only if you own a controlling stake in a company and can influence its direction can you guarentee making a difference. That being said once the market declines again I suspect we’ll see a shift of the public back to other types of mutual funds.

  2. Great post, WSP!

    I feel one variable that affects active management more than passive management is emotions.

    Maybe the hedge fund manager is being emotional with their funds and are stubborn that it will bounce back from a drop or maybe they sold it too fast because of the huge drop. These are things that passive investing won’t have if we just put money in and have a long-term vision for our investments.

  3. Great post-I’ve been watching this bet with great interest. As someone who doesn’t have the time to spend researching individual stocks, I’ve been a passive index investor for nearly 20 years now. I’ve “stayed the course” through the 2000 tech crash and the 2008 Great Recession, and found that simply owning the index was the best way to go. Looks like Warren’s going to win the bet! Of course, as you mentioned, their goal isn’t to beat the S&P 500. But for an ordinary investor, they should care about getting the best returns they can for the least amount of work. Indexing gives them that advantage at a low cost.

  4. I think if 1 has an investment strategy, stick with it. If you convert from passive to active management and vice Versa, you lose money. For example, me smith has 500k and he is unhappy that his portfolio manager is not investing on expensive stocks, moves his money to index since it is rising. He would have gained 20% 100k if he was in s&p 500. Then market crashes and loses 50% 250k so overall, he still lost 50% trying to get that 20% gain. Index fund is not mathematically sustainable is everyone goes to indexing. Then, there’s no point for market analysis. Many companies in s&p 500 have reported negative earnings since 2014 but prices still kept rising. The bet is until dec 31 2017. I am still strong supporter of my portfolio manager and I will not switch to indexing.

    • Thank you for your comment, Dr. V. John Bogle started the first index fund in the 1970s. It’s slowly become more popular over time, with an acceleration of its market share over the past few years as the S&P 500 has been handily outperforming mutual and hedge funds. In my opinion, we are a long way before index fund investing becomes mathematically unsustainable.

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