A Sucker's Bet
It’s not supposed to be over until it’s over - but since most of the results are already in – I guess it’s over. Hedge fund manager, Ted Seides of Protégé Partners, has conceded defeat before the “official” end of his public wager with billionaire investor Warren Buffett.
About ten years ago, Mr. Buffett, challenged any hedge fund manager to a head-to-head competition against a passive stock index fund over a ten-year period. He proclaimed that the index fund would earn a higher return after fees and expenses. Each side would put up one-half million dollars of their own money with the combined $1 million going to the winner’s designated charity. Mr. Seides was the only hedge fund manager brave enough to take up the challenge. He was allowed to choose any five hedge funds with each being a “fund of funds” representing collectively over 100 hedge funds. The results would be measured from January 1, 2008 to December 31, 2017.
The fund chosen by Mr. Buffett was the Vanguard S&P 500 Index Fund Admiral Shares with an expense ratio of 0.04 of 1%, which means fees of just $40 per year on a $100,000 investment. This passive investment would compete against the best the active investment world had to offer. By the end of 2016, the group of hedge funds was hopelessly behind the index fund and presumably is even further behind now. With just a few months until the end of the full ten years, it’s virtually impossible for the hedge funds to catch-up, leading Mr. Seides to publicly throw in the towel.
The Vanguard S&P 500 Index Fund earned a cumulative 85% for an average annual return of 7.1%. The collection of hedge funds gained just 22% in total during the same time for a paltry 2.2% per year. The index fund also beat each and every one of the five hedge funds handily. $100,000 invested in the index fund on January 1, 2008 would have been worth about $185,000 by the end of 2016, whereas the same amount in the hedge funds would have grown to just $122,000, a shortfall of $63,000! Despite this dismal performance, it should be noted that that hedge fund managers were paid handsomely for their efforts.
Hedge funds are investment pools that invest in a wide assortment of asset classes and employ a variety of complex strategies. Although some charge differently, they are known for the traditional price structure of “2 and 20,” which means fees of 2% of the assets under management plus 20% of any gains. Hedge funds don’t undergo as much regulation or have as much transparency as regular mutual funds and are marketed to so-called sophisticated investors, which must mean people with more money than brains. Why would investors give up 20% of the profits after already paying 2% of the asset base when taking all of the risk?
Hedge funds are not an asset class like stocks or bonds or real estate. They don’t generate a fundamental return unto themselves. They derive value in part from the underlying assets, but they also rely on the success of strategies and tactics employed. Different approaches work well in certain types of markets, but not so well in others. If you believe that financial markets are pretty efficient, meaning they incorporate all known information, it’s tough to outguess the markets on a consistent basis. This doesn’t mean that the markets are always rational or always reflect intrinsic value. After all, the markets are comprised of people and people are inheritably irrational, at times.
Buffett’s challenge was a “sucker’s bet,” because the index fund was destined to win under most possible scenarios. Under a moderate to strong market the Oracle of Omaha would likely win because of the huge cost advantage. The passive index fund charges virtually nothing, forcing the active hedge funds to beat the market by at least 2% per year in order to come out ahead. That’s not going to happen in a typical economic environment.
In a sluggish or side-ways market, whereby U.S. stocks go up and down and trend flat for many years, hedge funds might be able to capitalize on volatility. Even then though it would be difficult to overcome such a heavy expense drag.
Hedge funds would certainly have an advantage in a bear market, if it was long or deep enough. Thankfully, that doesn’t happen often. Of particular interest, the wager began at the start of the financial crisis. Mr. Seides was optimistic, because he expected a low return from stocks based on his assessment of their valuation at the time. In fact, the index fund lost 37% during the first year of the bet and lagged the hedge funds which limited losses to about 24% during that same time. The stock market recovered in just a few years and the index fund went on to crush the active funds.
In retrospect, it’s hard to see Mr. Buffett losing this bet, but that’s easy to say with the financial crisis in the rear view mirror. It’s an even bolder gamble when you put down your own money, and even more importantly, your reputation on the line. Mr. Buffett did what he has done many times in the past. He bet on the U.S. stock market, which means he put his faith in the U.S. economy.
I’m sure Mr. Buffett would be the first to tell you that “people” are critical to building and managing great businesses, which are the kind of businesses that he invests in as Chairman of Berkshire Hathaway. Humans are also important to create a “market” and to handle the efficient administration of the financial markets. However, people don’t add much to the portfolio management process. The reason for this is simple. Nobody can foresee the future. Without that ability, those hedge fund managers that Mr. Buffett calls “helpers” just add layers of expenses without adding economic value. By taking out the intermediaries, he knew that he could skew the odds in his favor.
The rest of us can learn from this and tilt the odds in our favor as well. Of course, most of us invest in mutual funds, rather than hedge funds, but active mutual funds are like hedge funds in that they attempt to beat the market using active strategies. Although most mutual funds charge closer to 1%, they are still likely to underperform a low-cost index fund of the same type, which makes them a bad bet.
The typical portfolio manager, who chooses mutual funds plays a similar role to Mr. Seides by adding another layer of fees. I call this the “1 plus 1” model, whereby active mutual funds charge about 1% and the portfolio manager adds 1% for a total of 2% per year to put together a collection of mediocre funds. This is like doubling down on a bad bet. Without a crystal ball, a money manager has no ability to select the best funds in advance or sidestep market declines. This common money management approach is destined to track the overall market, but will lag because of the 2% fee drag. The chance of coming out ahead with this approach is about the same as drawing to an inside straight. In my view, this makes almost any type of active money management - like Mr. Buffett’s wager with the hedge funds - a sucker’s bet.