In 2007, Warren Buffett entered into a famous bet that an unmanaged, low-cost S&P 500 stock index fund would out-perform an actively-managed group of high-cost hedge funds over the ten-year period from 2008 to 2017, when performance was measured net of fees, costs, and expenses. See previous CD posts about Buffett’s bet here and here. In Warren Buffett’s 2017 annual letter to shareholders (released on February 24, 2018), he summarized the result of his bet in the section “’The Bet’ is Over and Has Delivered an Unforeseen Investment Lesson” as follows:
Last year, at the 90% mark, I gave you a detailed report on a ten-year bet I made on December 19, 2007. Now I have the final tally – and, in several respects, it’s an eye-opener. I made the bet to publicize my conviction that my pick – a virtually cost-free investment in an unmanaged S&P 500 index fund – would, over time, deliver better results than those achieved by most investment professionals, however well-regarded and incentivized those “helpers” may be.
Addressing this question is of enormous importance. American investors pay staggering sums annually to advisors, often incurring several layers of consequential costs. In the aggregate, do these investors get their money’s worth? Indeed, again in the aggregate, do investors get anything for their outlays?
Protégé Partners, my counter-party to the bet, picked five “funds-of-funds” that it expected to over-perform the S&P 500. That was not a small sample. Those five funds-of-funds in turn owned interests in more than 200 hedge funds. Essentially, Protégé, an advisory firm that knew its way around Wall Street, selected five investment experts who, in turn, employed several hundred other investment experts, each managing his or her own hedge fund. This assemblage was an elite crew, loaded with brains, adrenaline and confidence. The managers of the five funds-of-funds possessed a further advantage: They could – and did – rearrange their portfolios of hedge funds during the ten years, investing with new “stars” while exiting their positions in hedge funds whose managers had lost their touch.
Every actor on Protégé’s side was highly incentivized: Both the fund-of-funds managers and the hedge-fund managers they selected significantly shared in gains, even those achieved simply because the market generally moves upwards. Those performance incentives, it should be emphasized, were frosting on a huge and tasty cake: Even if the funds lost money for their investors during the decade, their managers could grow very rich. That would occur because fixed fees averaging a staggering 2 1/2% of assets or so were paid every year by the fund-of-funds’ investors, with part of these fees going to the managers at the five funds-of-funds and the balance going to the 200-plus managers of the underlying hedge funds.
The final scorecard for the bet is summarized in the top chart above. The five funds-of-funds got off to a fast start, each beating the index fund in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund.
Let me emphasize that there was nothing aberrational about stock-market behavior over the ten-year stretch. If a poll of investment “experts” had been asked late in 2007 for a forecast of long-term common-stock returns, their guesses would have likely averaged close to the 8.5% actually delivered by the S&P 500. Making money in that environment should have been easy. Indeed, Wall Street “helpers” earned staggering sums. While this group prospered, however, many of their investors experienced a lost decade.
Performance comes, performance goes. Fees never falter.
A final lesson from our bet: Stick with big, “easy” decisions and eschew activity. During the ten-year bet, the 200-plus hedge-fund managers who were involved almost certainly made tens of thousands of buy and sell decisions. Most of those managers undoubtedly thought hard about their decisions, each of which they believed would prove advantageous. In the process of investing, they studied 10-Ks, interviewed managements, read trade journals and conferred with Wall Street analysts.
The ten-year betting period officially ended on December 31, 2017 although Buffett was so far ahead by mid-2017 that hedge fund manager Ted Seides of Protégé Partners conceded early. As the New York Post reported in September 2017 “Seides’ $1 million hedge fund investments have only earned $220,000 in the same period that Buffett’s low-fee investment gained $854,000. ‘For all intents and purposes, the game is over. I lost,’ Seides wrote.”
If in 2010, Buffett (or anybody else) had entered into a 10-year bet that a low-cost S&P 500 index fund would out-perform the average hedge fund from 2011 to 2020, Buffett would have easily won again. The bottom chart above shows the average annual returns from the average hedge fund (data here) and the S&P 500 index (data here) from 2011 to 2020. In each of the last ten years, the return on the S&P 500 was greater than the return on the average hedge fund, and in seven of those years the return on the S&P 500 was two times higher or more, and in four years it was three times higher or more. Over the decade, the average annual return on the S&P 500 was 14.41% or almost three times higher than the 4.96% average return for hedge funds. In dollar terms, a $100,000 investment at the beginning of 2011 in the average hedge fund would have grown to only $159, 375 at the end of last year compared to a payoff of more than twice that amount — $364,678 — invested in the S&P 500! Not. Even. Close.
Over the most recent ten-year period, Buffett’s investment advice from his 2016 letter to shareholders has convincingly prevailed:
A lot of very smart people set out to do better than average in securities markets. Call them active investors. Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund.Therefore, the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.
Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.
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. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.
Repeat: Most investors will get better financial results over time with with low-cost, unmanaged index funds than from high-cost actively managed stock funds and hedge funds run by highly-paid investment professionals, however well-regarded and incentivized those “helpers” may be.
MP: To get started following Warren Buffett’s investment advice, if you haven’t already, you can open an account in the Vanguard 500 Index Fund Admiral Shares with a minimum investment of $3,000 and the expense ratio is almost zero — only 0.04% (1/25th of one percent) or only $4 per year for every $10,000 invested!
Related: The Motley Fool’s Morgan Housel’s classic “Two Hedge Fund Managers Walk Into a Bar…“