by Stewart Darrell, CFA

 

Nine years ago Warren Buffett offered a wager that the S&P 500 would outperform hedge funds over an extended period of time.  Only one individual, Ted Seides of Protégé Partners, rose to the challenge.  The terms were set with $1 million at stake over a ten-year period beginning January 1, 2008, with the proceeds going to charity.  Warren Buffett chose the Vanguard S&P index fund to square off against a portfolio of five hedge funds selected by Ted Seides.  As one of the most successful investors of all time and the second richest person in the world, Warren Buffet is a household name.  Ted Seides most certainly is not, but he was well-known in hedge fund circles at the time as the co-founder of Protégé Partners.  As an investment firm, Protégé invests exclusively in portfolios comprised of the hedge funds it selects.  To understand the magnitude of this bet and the players, it is helpful to have the following perspective.

 

March 2000 marked the peak of the tech bubble and the end of the longest, most robust bull market on record.  With the dawn of the new millennium, a hangover quickly set in.  Peak to trough, the S&P 500 dropped 49% between March 2000 and October 2002.  It also registered three negative calendar years in a row.  Exhausted, investors were primed for something new, and they found it in hedge funds.  These complex, pooled investment funds promised significant returns with protection on the downside via derivatives, leverage and short selling – a true panacea.

 

As Warren Buffett and Ted Seides were shaking hands to solidify their bet, hedge funds were the darlings of the investment world.  The hedge fund industry had ballooned in assets from $173 billion in 1997 to $3.3 trillion by 2007.  Growth came despite exorbitant costs to investors, including 2% annual management fees and hefty performance fees.  Lucrative pay packages coaxed the world’s best and brightest graduates to shun careers in medicine, science and engineering to pursue their fortunes working at hedge funds.  It was against this backdrop that the improbable bet was made.  With one year left on the 10-year wager, the results stand as follows:

 

Cumulative Return Annualized Return (per year)
S&P 500 index fund (Buffet) 85.4% 7.1%
5 Hedge Funds (Seides) 22.0% 2.2%

*Returns are calculated net of fees for the calendar years 2008 – 2016 and were detailed in Buffett’s 2016 letter to Berkshire Hathaway shareholders.  Cumulative and annualized hedge fund returns represent the average performance of the 5 selected hedge funds.

 

These results illustrate how a simple, low-cost index fund outperformed some very sophisticated investment minds.  This wager is another illustration reinforcing our fundamental tenet that the odds are against hedge funds and professional stock pickers charging high fees for active management.

 

At Harris Financial Advisors, we favor low-cost, index-based equity strategies that tilt toward factors offering high probabilities of solid returns over time.  While these strategies offer enhancements compared to straight index funds, it always feels good to be on the same page as Warren Buffett.

 

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