Buffett bets on an index – third year update

John Osbon - June 1, 2011

If you enjoy the speed and excitement of slot machines or blackjack, this is not the wager for you: Warren Buffett bet that the unmanaged S&P 500 would beat actively managed hedge funds over a ten year period. The bet launched at the beginning of 2008, and we now have updated results for the first three years.

As we said in an article in mid-2008, our money is on Buffett, even though the deck seems stacked against the passively managed S&P:

“The owners of Protégé Partners, which runs funds of hedge funds, handpicked five funds of funds for its side of the bet. These funds have at their disposal all the tools of active management, including state-of-the-art fundamental and technical analysis, the freedom to buy and sell at any time, and the opportunity to modify strategies as markets evolve over time. And as hedge funds, they have the added flexibility of using leverage and short-selling to amplify returns, even when security prices are falling.” Read our full 2008 article.

Who’s winning?

In 2008, the hedgers won…or at least lost less. In that awful down year for the markets, both sides floundered.  The S&P fell 37 percent, even worse than the 24 percent lost by the hedge funds chosen by Protégé.

In the two years since, the simple buy and hold protocol of the S&P trounced the hedge funds. The index was up 26 and 15 percent for 2009 and 2010, far better than the 15 and 8 percent gains of the hedge funds. Read the 2010 results update from Fortune.

The outperformance of the hedge funds in the chaos of 2008 makes sense, of course, given the flexibility to get out of weak stocks and sectors, sell short, and so on. But the underperformance of the hedge funds in 2009 and 2010, I feel, would be far harder to explain to investors in those funds. The carefully made decisions of the fund managers – based on years of experience, expensive modeling and comprehensive research – turned very good years into very mediocre ones. By doing more, they earned less.

Expenses hinder hedgers

Management costs are central to any gap in performance.  Buffett’s expenses via Vanguard’s Admiral shares are essentially zero – less than 10 basis points a year – while the fund of funds model extracts several layers of substantial fees. These expenses make keeping up with an index that much harder, especially in up years, as an extra slice of profits go straight to the fund managers. More on funds of funds and related expenses.

(The hedge funds are also more likely to generate taxable income through short-term buying and selling, compared to the low-turnover index fund.)

Not yet halftime

Because 2008 was so traumatic, both teams are still underwater for the three-year period. Protégé is down 4.2 percent. The S&P is down 8.2 percent. Both sides would likely emphasize that this is a ten-year wager (all winnings go to charity, by the way), and we are not even to halftime yet. With seven years left, we still expect Buffett to win the bet. Index investing may seem too simple for some high end investors, but I feel its simplicity is its advantage. An indexer not only eliminates needless expenses, but removes the temptation to tinker with a portfolio based on what’s happening in the news or market pundits fussing over the hot security du jour.

Anything can happen over the next seven years and probably will, but I’m very glad Mr. Buffett made this bet. I think the results will most likely show that indexing is a sound, rational investment approach, especially for individual investors with long time horizons. There’s plenty of existing academic research that shows how indexes typically outperform actively managed assets, but this real world example may change more minds.

We will keep an eye on it and keep you posted.

 

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