The (now reasonably infamous) Warren Buffett bet has reached its conclusion. The original can be found at longbets.com.

LongBets.com is a website that allows rich opinionated people to put not-a-lot-of-their-money-really where their public mouth is. Warren Buffett put up this particular 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 Bet

Basically:

1. Warren Buffett believed 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 believed 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 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 Outcome

So what has happened since January 2008?

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

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.

And yet, even with that headstart, the hedge funds still came second. All five of them.

The 2017 Berkshire Hathaway Letter

In his most recent shareholder’s letter, Warren Buffett declared himself the winner.

In his words:

“Performance comes, performance goes. Fees never falter.”

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

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

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.