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Robert Abbott
Robert Abbott
Articles (340)  | Author's Website |

Warren Buffett vs. Hedge Funds: And the Winner Is…

The results are now in from a big bet made 10 years ago

January 12, 2018 | About:

“Bogle’s Folly, as the first index fund was derisively described, seems to have morphed into Buffett’s Revenge.” --Barry Ritholtz

On the first day of 2018, a bet undertaken on the first day of 2008 came to a close. It pitted Warren Buffett (Trades, Portfolio) against Protégé Partners LLC, a hedge fund.

More specifically, it was a bet between an index fund and a funds-of-funds hedge fund. Or, it might be said, passive investing versus active investing. The original agreement is listed at Long Bets, along with a short opening argument for each side. No one has been a more successful active investor than Buffett, yet he insists most investors will be better served with passive funds.

The reason? Fees. Among his many attacks on high fees is this one from the 2014 letter to shareholders:

“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool's game.”

The broader point being made by Buffett is that of any successful business: keep your costs under control. That’s obviously tough for hedge fund investors who pay the standard 2% management fee, plus 20% of profits above a specified high-water mark. On the other hand, index investors pay just a fraction of 1%.

Buffett threw out his challenge at the 2007 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) shareholder meeting. He offered to bet anyone $1 million that over the next 10 years, and after fees, the S&P 500 index would beat any 10 hedge funds that an opponent might select. Protégé Partners took up the challenge.

For the bet, Buffett chose the Vanguard 500 Index Fund Admiral Shares (VFIAX), with a fee of 0.04%, while Ted Seides of Protégé chose the average of five funds of hedge funds he would handpick himself.

Whoever generated the highest returns, net of fees, for the 10 years ending Dec. 31, 2017 would win a $1 million prize for the charity of his choice. The loser would pay that million, of course (the principals, rather than their firms).

The deadline passed a couple of weeks ago and Buffett was declared the winner, as he handily whipped Protégé Partners. In fact, it was not even close (per results shown at Fortune):

  • Buffett’s S&P 500 index fund: 7.1% compounded annually (up 85.4%).
  • Protégé’s basket of hedge funds: 2.2% compounded annually (up 22%).

Many observers have analyzed the results, looking beyond just the basic returns.

At The Motley Fool, the writer argues all investors who try to beat the market are active investors; it is not just hedge fund managers. The same holds for actively managed mutual funds. He winds up by saying, “When you give your hard-earned money to a fund manager, you're making a bet, the odds of which are not in your favor.”

Roger Lowenstein wrote, in a Fortune article, that over the eight years the bet had then been running, performance of the S&P 500 was mediocre at best, about 6.5% per year. But a hedge fund that wanted to beat that 6.5% would need to return 9% per year — after fees.

He adds Protégé faced an even higher hurdle because it chose to use funds of funds. That meant covering not only the original hedge fund fees, but also the fees to the manager picking the hedge funds. According to Lowenstein, Protégé needed at an extra return of at least 3% per year, rather than 2.5%, to compensate for fees.

Then, there is the problem of diversification. Lowenstein says Protégé is working with funds of funds and, as a result, probably owns more than 1,000 different securities. That, he says, "would make it pretty close to an index fund–only with super-high fees.” In addition, “Extreme diversification inevitably drives results toward the mean.”

Lowenstein says he spoke with Seides, who managed the Protégé side of the bet (for the first part of the 10 years). Seides reported his funds of funds had delivered a gross return (before fees) of some 5% per year in the first eight years.

Seides also told Lowenstein he had taken the bet as a “referendum” on the S&P 500, which then “vastly outperformed” his expectations.

Since this bet was made at the beginning of 2008, it is fair to say Seides made a great short-term call as the market went into meltdown just months later. Then, it rebounded sooner than most observers expected.

There may also be a value factor involved in the outcome. Protégé is reported, by the Vanguard Blog, to favor value-oriented strategies. The past decade has been a tough one for many active value investors as bargains have become harder to find.

Writing for Forbes, Elizabeth Harris says, “As a lot of research has shown, it is nearly impossible for any single fund manager or investing algorithm — no matter how brilliant or sophisticated — to outperform the market every year for 10 years in a row.”

To all of this I would add there was a certain amount of luck in regard to timing. Had there been another severe downturn after five to eight years of the current bull market, Seides’ perspective might have looked more reasonable. A loss of the magnitude of 2008, 37%, would have likely have improved Seides’ results and significantly diminished Buffett’s results.

In conclusion, investing in the services of hedge funds is unlikely to be a good investment.

Typical hedge funds use a long-short strategy, which theoretically allows them to profit when the market is bullish and not lose too much when the market turns bearish.

That would seem a sensible strategy; after all, Buffett himself has said the first rule of investing is not to lose money and the second rule is to reread the first rule.

Yet, it is a flawed strategy because it is essentially a market timing strategy. Carry too much hedging and you suffer through the bull years, carry too little and you lose in sharp downturns. In profiling dozens of gurus, I have seen too many who did well in the boom before the financial crisis, then had trouble beating their benchmarks after.

Once again, the tortoise beats the hare.

Disclosure: I do not own shares in any of the securities listed, and I do not expect to buy any in the next 72 hours.

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald's Profits?, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

Visit Robert Abbott's Website

Rating: 5.0/5 (1 vote)



Narrog premium member - 9 months ago
This is an intriguing issue. I suppose the outcome was mainly determined by (1) timing, as you write, and (2) negative factors in the structure of the average hedge fund, like (a) heavy cost structure and (b) a strong tendency to clandestinely track the index because of performance pressure on the managers. (2)(a) and (b) combined practically "guarantee" underperformance.

But I think Seides' lost especially because he had to bet on "funds of funds" because of legal issues in the contract with Buffett. That made him bet on a bunch of average funds that suffer from intrinsic structural problems. If he had chosen individual funds with a proven record of outperformance, like Renaissance or Howard Marks (Trades, Portfolio)' Oaktree, he could still have won it. I would have liked to choose those funds! (Who wouldn't?)

The problem for us retail investors, unless we are really high net worth, is that the really good funds, like Renaissance, are closed to us. We have to go for the average 2-20 fund that is destined for underperformance. In this sense, the bet was representative.

LwC - 9 months ago    Report SPAM

@Narrog: AFAIK Seides *chose* his method of investing in fund-of-funds. He didn’t “have” to bet that way. In fact, presumably if he thought that he would lose the bet by investing that way, he would not have made that bet. Buffett wasn’t holding a gun to his head, saying “bet this way or else.”

Here’s what Mr. Buffett has written:

“In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained 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.

Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?

MP: Specifically, Buffett offered to bet that over a ten-year period from January 1, 2008, to December 31, 2017, the S&P 500 index would outperform a portfolio of funds of hedge funds when performance is measured on a basis net of fees, costs and all expenses.

What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds.

I hadn’t known Ted before our wager, but I like him and admire his willingness to put his money where his mouth was. He has been both straight-forward with me and meticulous in supplying all the data that both he and I have needed to monitor the bet.

For Protégé Partners’ side of our ten-year bet, Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager.” [Bold emphasis added by me]

Narrog premium member - 9 months ago

@LwC. Thank you for your clarifying comment and the very welcome additional information. I think the problem is mainly in the wording. According to Seides' telling, in a recent interview with The Investors' Podcast, he was fully convinced at that time that he would win the bet. And he still believes that the main reason for losing it was timing (the S&P going on an almost unprecedented roll in the next ten years). On the other hand, with respect to the choice of funds, he also mentioned that he had to go with funds-of-funds because of legal issues with the bet arising if he had picked individual funds. Presumably these were issues like the evaluation of the outcome if one or more of the funds had closed shop during the period of the bet.

So Seides was surely not "forced" to pick funds-of-funds, and he stood behind his picks and his bet, but it seems that he didn't have the choice to pick individual funds either. So,my wording he "had to" is in this sense . It is intriguing to think what would have happened if he had had the option to choose individual funds, and on top of that had actually done so, isn't it? Especially for us as subscribers of GuruFocus. After all, if we would not have the conviction that there ARE individual fund managers who have the ability to outperform a given index over an extended period of time -- and there wouldn't be data that support this conviciton --, we wouldn't be subscribing to this site, and instead put our money into an index fund. That's what I wanted to express.

(I hope that I am not double posting this. I am trying to upload it for the fourth time.)

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