Why Warren Buffet bet a million Dollars against active investing

In the highly charged debate over active vs. passive investing, billionaire investor Warren Buffett put his money where his mouth is and he is about to take home a million dollars for his troubles. Over the years, Buffett has made no secret of his contempt for hedge funds, particularly their compensation structure, which, he complains, rewards fund managers for nonperformance.  So, convinced he was that hedge funds are not able to overcome their high fees to deliver market-beating returns, he bet them $1 million of his own money that a low-cost S&P 500 index fund could outperform a portfolio of hedge funds.  That was in 2008 and, short of a disastrous market decline in the next several months, he is about to collect on his bet.

 

Buffett’s big problem with active managers

Buffett has long been a vocal critic of aggressive hedge fund strategies, not just for the outsized fees they charge; but also for having introduced short term volatility to the markets through high frequency trading. He has also come down hard on the aggressive tactics of activist investors, such as Daniel Loeb and Bill Ackerman. Buffet is an active investor himself, buying and selling stocks based on fundamental analysis, but he is of buy-and-hold variety. For average investors, he has always encouraged the use of low-cost, passively managed funds as a way to achieve the best long-term performance. The trusts he set up for his grandchildren are invested in index and exchange-trade funds (ETFs).

 

The big bet

In 2008, Buffett issued a challenge to the hedge fund industry, which was accepted by Protégé Partners LLC. At the core of the bet is Buffet’s contention that an S&P 500 index fund, including fees and expenses, would outperform a portfolio of select hedge funds over a 10-year period. The bet, which runs through the end of 2017, essentially pits passive style investing against active style investing in a direct confrontation.  The winner of the bet will donate the $1 million to a charity of their choice.

Through February 2017, with 10 months left, Buffet is well ahead, leading the hedge fund portfolio by more than 63 points. Buffet chose for the index fund investment, the Vanguard S&P 500 Admiral’s fund, which is up 85.4%. Protégé’s hedge fund portfolio is up 22%. But, it hasn’t been a completely smooth ride for Buffet. Early on, when the stock market was tanking in 2008, Protégé’s portfolio showed what the hedge in hedge fund was all about by limiting its decline to 24% while Buffett’s index fund lost 37%. It took four years for the index fund to pull ahead of the hedge fund portfolio in terms of cumulative return. In the choppy stock market of 2015, the hedge fund portfolio did its job again by outgaining the index fund, 1.7% to 1.4%. In 2016, the index bounced back with an 11.9% gain to Protégé’s 0.9%. Absent a steep downturn between now and the end of the year, Buffet should cruise to victory.

 

And the winner is….

 While this is not likely to settle the debate between passive and active investing, it does offer interesting fodder for both sides of the argument. Buffet and passive investors can point to the fact that a passively index fund outperformed an actively managed hedge fund portfolio over a 10-year period. Active investors can point to the performance of the hedge funds during down markets and periods of volatility, which is when they are expected to outperform. The fact is that Protégé did outperform the S&P 500 index, 95% to 64% in the five year period leading up to the 2008 market crash. While the debate can be expected to rage on, the true winner for now is Buffet’s charity, Girls Incorporated of Omaha.

 

An important investing note

While Buffet’s achievement should be celebrated as a win for passive investors, it is important to note that investing in any single index, such as the S&P 500, could expose you to greater risk or limit your returns in any given year. In any given market cycle, the S&P 500, which is comprised of the 500 largest companies in the U.S., does not always perform as well as other indexes. For example, when international stocks are performing well, U.S. stocks tend to underperform. Or, when bonds perform well, stocks usually don’t. Although it wasn’t practical for Buffet to diversify his indexes for purpose of the bet, investors are better served by a broadly diversified portfolio of indexes representing various market segments and asset groups.

 

Author: Vitali Butbaev, Velstand Capital Founder
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