If you’ve never heard of it, there’s a website called LongBets.com which allows rich opinionated people to put not-a-lot-of-their-money-really where their public mouth is. Warren Buffett last put up a bet in 2008: and it involved his ongoing love affair with low cost index-linked funds. Specifically, he thinks that you and me, and some of his rich friends, should not bother with hedge funds. We should just put all our money into index-linked funds like the Satrix.

The Index-Linked Fund Bet

Warren Buffett's bet

Basically:

  1. Warren Buffett believes that you should forget about out-performing the market. Rather go with a low cost option that tracks the market index.
  2. Protégé Partners LLC believes that a portfolio of funds of hedge funds is totally worth the fees.

Before I get to their arguments, just a explanatory note about ‘funds of funds’.

What are funds of funds?

In the finance world, you get hedge funds that try to employ some type of investment strategy. Those are your standard, garden-variety style of hedge fund. And they will charge fees that are usually constructed as:

  • 2% of the total investment that you place with them, each year (the “Assets Under Management” fee); and
  • 25% of the ‘outperformance’ of the investment each year, relative to some pre-agreed benchmark, like the S&P 500 (the “Performance” fee).

But there are two problems here:

  1. Hedge Funds don’t like small investments or small investors. Because hedge funds sometimes involve themselves in long-term and tricky strategies that may take years to realise themselves, most hedge funds do not open themselves up to small investors. They prefer large investors, who are willing to lock in their money for long periods. This also makes the fund easier to administrate (and more profitable).
  2. Investors like to diversify their risk. You might want to split your money between a number of hedge fund managers, as that prevents you from being locked into the performance of one specific fund manager.

So the hedge fund solution: funds of funds. These are hedge funds that take your money, and then on-invest it into a variety of standard hedge funds. And for doing this, they’ll usually charge a further “Assets Under Management” fee atop the fees of the standard hedge funds (perhaps a further 1%).

And in term of fees, you’re looking at a minimum annual fee of around 3% of your investment, excluding any performance fees.

So if you compare this to the 0.8% or so that you’d pay on an index-linked fund (and sometimes, even less), hedge funds of funds cost almost three times as much.

Which is pretty much the argument that Warren Buffett is making: those higher fees represent a barrier to performance that Hedge Funds are highly unlikely to beat.

The Bet Argument

The index-linked fund v hedge fund argument

So I’ve already mentioned WB’s issue with fees. Here’s Protégé Partners’ summarised response:

Dear Warren

You’re wrong.

We’re totally worth the higher fees.

Your index-linked funds can only benefit from shares going up in price.

Our hedge funds can also take short bets on shares going down in price.

This means that we can aim to never lose money – because we can make money for our investors when the market goes up AND make money for our investors when the market goes down.

Your index-funds, on the other hand, will ALWAYS lose money when the market goes down.

We’ll take your bet.

The Progress

So what has happened since January 2008?

Well, the S&P 500 tanked over 2008/2009 – and has spent the time since then recovering:

S&P 500 performance since 1 January 2008

I mean: what luck for Protégé Partners LLC, right? They could make all that money over the big crash, and then even more in the subsequent downturns in mid-2010, mid-2011, mid-2012, mid-2015 and early 2016. And then they get all the upside of the recovery as well!

Meanwhile, Warren Buffett’s index-related fund would have tanked in 2008/2009, and then only had the benefit of the recovery since.

The 2016 Berkshire Hathaway Letter

In his most recent shareholder’s letter, Warren Buffett re-told this story. Some might call it ‘crowing’.

In his words:

“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?

“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.

“Each fund-of-funds, of course, operated with a layer of fees that sat above the fees charged by the hedge funds in which it had invested. In this doubling-up arrangement, the larger fees were levied by the underlying hedge funds; each of the fund-of-funds imposed an additional fee for its presumed skills in selecting hedge-fund managers.”

Calling It

Then, a status update (with a year to go on the bet):

The Warren Buffett Bet status at the end of 2016

Which is, you know, awkward for hedge funds of funds.

But good news for everyone that puts their money into exchange-traded funds though.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.