Post: Warren Buffett’s Million Dollar Bet

Warren Buffett’s Million Dollar Bet

Warren Buffett has just won a 10-year million dollar bet. The outcome is highly significant because it pitches two entire philosophies of investment against one another. On the one hand you've got very cheap tracker funds these just buy an entire market like the FTSE 100 or the S&P 500 and you pay a very small fee for that.

On the other hand, you can pay much more for a hedge fund manager where you pay for their skill to perform well in any kind of market. On the way we're going to learn about long/short funds and also fund of funds which is another approach to hedge fund investing.

Here's Warren Buffett's CV. He starts off every letter to his investors with this table. It shows his annual returns versus the S&P 500 since nineteen sixty-five. His average return is 21% whereas the S&P 500 only returned about ten percent over that period. He produced double the return of the US stock market as a whole. That means he's got a 52-year record of beating the market. If you invested $19 with Warren Buffett's fund in 1965 it would now be worth $172,000. Although 20% may not sound amazing it's Buffett's consistency in beating the market over such a long period of time which is astonishing and extremely rare.

The Long Bets website was seeded by Jeff Bezos. It's a charitable foundation and you can see the featured bet at the moment is the one between Warren Buffett and Protégé Partners, a hedge fund. The stake is a million dollars and the bet is that the S&P 500 will outperform a portfolio of funds of hedge funds. These are the rock stars of the fund management industry. But the last part of the sentence is crucial "when performance is measured on a basis net of fees, costs and expenses". Hedge funds often perform very well but that fund performance comes at a cost. There are some ground rules: the minimum period of the bets is two years, you can't just bet on racehorses or the flip of a coin it has to be societally or scientifically important. You have to explain why you think it's important and why you're right and you have to name a charity to receive the winnings.

The bet grew out of a statement from Warren Buffett in 2005. I remember at the time people thought he was crazy. Everyone was in awe of hedge funds, and yet this old guy was saying that they'd be blown out of the water by just tracking the whole index. We thought that was impossible! It took a while but Ted Seides who was the president and co-CIO of Protégé Partners at that time came forward with a counter-bet. Here are the two sides of the argument from the Long Bets website.

First things first you have to understand what a fund is. You have a group of investors, they have some spare cash, they invest that money into a fund then an extremely intelligent well-resourced active fund manager invests that money. He can put it into shares, bonds, commodities, property... If he's a skillful investor that combination of assets will give very good returns for the investors. In the diagram the returns (dollar signs) are reinvested back into the fund, and of course some of those returns go to the active fund manager as a fee.

The fund manager will charge you an annual fee according to the amount you invest so if you invest a hundred dollars and he charges 1% then every year you'll be charged one dollar. Hedge funds are infamous because they also take twenty percent or a fifth of any profits that they make. They charge two percent of the assets under management so on your hundred dollars you'd pay two dollars every year. In addition, if they make a profit they take a fifth of that profit. Not only are they highly-skilled, hedge fund managers are highly incentivized to make a very large profit because it directly affects their compensation.

How about a fund of funds manager? Just as before we have investors that put their money into the fund but instead of buying individual assets the fund manager invests that into other funds. The fund of funds manager will be actively looking for hedge fund managers which are the best performers and he'll combine them in an optimal way, which usually involves some diversification across different investment strategies, asset classes and country. The drawback is that there are now two levels of fees: fees for the individual fund managers at the bottom but also a layer of fees for the fund of funds manager.

How about the passive fund that Warren Buffett was talking about? What is the role of the passive fund manager? Well it's actually very simple: they simply buy a whole index. For example, if the fund is tracking the S&P 500 they would just buy all of the stocks in the index and if they do this in large scale for a large fund they can do it very cheaply. Those returns from the S&P 500 are put back into the fund and the fee is paid to the passive fund manager, but critically it is a very small fee. Whereas a hedge fund is 1% to 2% per year, an S&P 500 tracker can be as cheap as 0.07% per year which is more than 10 times cheaper. The standing joke is that Fund of Funds (FoF) is short for Fees on Fees.

Hedge funds would contend that the fund of fund manager is so skilled that they'd be able to boost the returns to amply compensate for the extra layer of fees. Warren Buffett disagrees. He acknowledges that the people who run hedge funds are very smart people but he says that their extra IQ is self- neutralizing, that it won't overcome the extra costs that they impose and his crazy statement is that investors would do better with a low-cost index fund. Warren Buffett's hero is John Bogle, who has been the long-term champion of low-cost funds. He set up the asset management company Vanguard and now he has a cult following. His fan club call themselves "Bogleheads".

Another argument in favour of hedge funds is that they can be long and they can be short. Everybody's familiar with being long a stock; you just buy the stock. If the stock price rises you make a profit if the stock price falls you make a loss, and the trick is to buy low and sell high. Well you don't actually have to do it in that order. You can sell high and then buy the stock back when it's low. This is called shorting a stock. First you borrow the stock from somebody, you sell it, and then hopefully you can buy it back at a lower price. Effectively this means you're left with a position we have minus one stock so if the stock price rises you make a loss but if the stock price falls you make a profit.

Most pension funds, and probably your pension fund, is a long only strategy. Their goal is just to beat the market and they avoid shorting stocks. Their measure of success is how much they beat the market so if they're trying to beat the S&P 500 their success will be measured relative to the S&P 500. That can create a crazy situation in which the market falls by thirty percent, their fund falls by "only" twenty percent and they'd consider that a screaming success!

Some hedge funds operate a long/short strategy. Instead of buying more or less of a stock that they like and don't like relative to some index they're just trying to make as much money as possible they don't care about relative return they just want absolute return. So if the market were to fall by minus thirty percent and if their fund fell by minus twenty percent that would be abject failure. The beauty of the long short strategy is that if you have just the right mix of long stocks and short stocks you can cancel out the overall market sensitivity. So if the S&P rises or falls you don't care. You make money if your longs rally and your shorts fall.

And Ted Seides makes that argument. Hedge funds have this flexibility to be both long and short and that means at least they have the possibility of generating positive return even if the market's falling. They're not handcuffed to the market anymore.

Well let's have a look and see how well that fund of funds performed. Here are the annual returns of the funds "A" to "E". Fund C's total return over this period was sixty-three percent which is okay, or at least it seems okay until you see what the S&P has done. That's up by eighty-five percent. In other words, the dumb strategy of buying the S&P 10 years ago and holding onto it with cheap fees would have outperformed all five hedge funds. If you annualize those returns the S&P 500 returned about 7.1% over that decade but the hedge funds only delivered 2.2%. A million dollars invested in the fund of funds would only have gained about 220,000 dollars whereas the S&P 500 would have gained eight hundred and fifty-four thousand dollars.

And now we get onto the sticky subject of fees. Buffett complains that the hedge funds get their two percent annual fixed fee even if they generate a huge loss and in great years they get that twenty percent extra out of the profits which you can't claw back if you have a bad year. He describes that fee arrangement as "lopsided" because it favours the hedge fund manager. Even if hedge fund managers have performed poorly they could still become extraordinarily rich as long as they can pile up their assets under management. Buffett estimates that about sixty percent of the gains achieved by the fund of funds was hoovered up into fees by the two levels of managers and he describes that as a misbegotten reward.

So although this is a sad story for hedge fund investors it's a great story for Girls Incorporated of Omaha who will certainly be receiving their million-dollar check at the end of this year.

Is there another Warren Buffett out there for you? Well yes, certainly! but the problem is that he's extremely rare so the chances of you choosing him are extremely low. One possibility would be time travel. Travel 52 years into the future select your "warren buffett" then come back and invest your pension.

Assuming you don't have a time machine another approach is just to use simple asset allocation. Keep the number of funds low, keep the fees low, dial your equity allocation up and down according to your risk tolerance and your age, try to go for big, liquid funds and use diversification as much as possible. Avoid behavioral pitfalls like selling in a crisis and timing the market and make sure that once in a while you rebalance your portfolio just to keep your allocation strategy on track.

Remember this is not a recommendation. If you want financial advice tailored to your individual circumstances seek independent financial advice.

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