Warren Buffett recently bet an ambitious hedge fund operator $1 million that
they won’t beat the returns of S&P 500 after their extremely hefty fees are
accounted for. Buffett claims investors will do as well with a no-load index
fund over the ten years of the bet. He has long been critical of the performance
claims of hedge funds, and his bet is intended to put his money where his mouth
is.
Details here. Of course, my money is with Buffett. Even if he doesn’t win the bet he is correct about the advantages of index funds. The academic research on this topic is voluminous and the lesson is straightforward – mutual fund managers don’t beat the market on average. Note that this doesn’t mean the market is perfectly efficient but it does mean that *you* are unlikely to beat the market. For more see my earlier post and also one of Tyler’s.
But I’m special! I will beat the odds!!!!!
Buffett himself is only 60% certain that he will win.
If the hedge funds were limited to long US S&P stocks, then it would be a much better bet.
A hedge fund could pick alternative investments and assuming that their returns are greater then the S&P, easily beat the index less expenses.
Overall, you have to like Buffett’s bet, since the expenses are a difficult hurdle. This will be an interesting argument for passive investing. University trust funds have been on a hot streak, and it will also be interesting to see how they do this year. Their fiscal year is June to June. One interesting thing about them is that, in theory, they have a much longer investment horizon then individuals, but if they take a major haircut, they will be under the same enormous pressure that all other asset managers face
I doubt Berk’s return on assets exceeds that of an index fund. Levered up (cheaply due to insurance in Berk’s case) corporate bonds can beat S&P index fund returns.
So, for years, I’ve heard that “no-load mutual funds” or low-fee S&P Index funds are the way to go for long-term investments, but in the limited research I’ve done, I haven’t found a very efficient way of finding these (or at least finding the funds with the “lowest” fees). Moreover, how would I go about purchasing them? Surely not find some financial planner and say, “I want to make the most money I can while paying you the least I can”?
So I guess I’m looking for advise from some more experienced investors. Is an E-trade account plus a Vangaurd S&P Index the optimal solution here?
mravery,
No need for an E-trade account. You can set up an account with Vanguard directly.
mravery:
morningstar.com
Alex,
Your comment would frustrate Buffett and Munger, who have spent plenty of time arguing against efficient market theory.
The reason that Buffett is a safe bet is not because markets are efficient, but because over long periods of time, the inefficiencies that active managers can exploit tend to get washed out by the additional transactions costs and management fees demanded by active managers.
If you’re the active manager and you follow the rules laid out by Graham, Buffett, and Munger, you’re actually quite likely to beat the markets over a long period of time.
Note that this doesn’t mean that I disagree that index funds are the best investment for most people! Most people don’t have the time, interest, or personality required to be good active managers of their own money.
The issue I’d worry about is that the bet is something that the manager will want to win. One million might not be that big a deal in and of itself (and if it were, watch out) but the publicity involved in winning would be worth a lot. Thus, the issue is that the manager may decide that it is in his interest to take large risks in the final year, betting on things enough to squeak past the S&P at the buzzer if things are remotely close and he’s losing, or playing it very conservative at the end if he is winning. Matching the S&P to guard against its movements is easy enough, and you might not have to be all that good to be a favorite if you take that approach.
Michael,
If it’s so likely that you can beat the market by following some rules, why do over 90% of all mutual funds underperform the S&P 500 over long periods of time? Are all their managers incompetent, or perhaps lacking in time, interest, and personality?
Talk about a conflict of interest!
Hey guys…..the $1 million rounds to zero with hedgies/Buffett. They each put up $320k in zero coupon bonds to fund the $1 million payout.
The bet won’t influence the hedge funds in any respect. Just buying the S&P with leverage isn’t necessarily a winner either. Leverage costs money and bites you badly on the way down. Not to mention trying to overcome the fees.
It isn’t all that complicated, it’s just a simple bet.
Buffett says that his chances are 60% of winning (but he tends to be very conservative)
The hedge fund guy thinks he has an 85% chance of winning.
There are multiple ways to achieve leverage; Vanguard essentially becomes levered if the companies it owns are levered.
“This can’t be a bet by Buffett in favor of EMT”
It is more of an argument regarding the headwind of investment expenses. Per Buffett, in aggregate, investment expenses eat up a substantial portion of all corporate profits. If you use a long term return of 9%, inflation of 3%, investment expenses can easily eat up 2 or 3 percent of the real 6% return.
You can use whatever figures seem appropriate (move all my assumed figures up or down to fit your view), but I haven’t even considered taxes. After everyone gets their taste, there isn’t much left for the investor. If you compare total ‘friction’ from active management, which include explicit fees as well as all sorts of minor transaction costs, a substantial portion of public company profits are consumed by the ‘helpers’ who by definition, in aggregate, beat the average.
When physicists and engineers make simplifying assumptions — frictionless surfaces, lack of air resistance, spherical cows — they don’t fool themselves into thinking that the simplification actually represents reality.
But economists? I have a sneaking suspicion that the efficient markets hypothesis started out as a simplying assumption, just to make some bit of math work out. And somehow over time it got elevated into an article of faith. Economists convinced themselves that it actually did represent reality.
This was a very poor time for Buffett to make that particular bet.
The S&P is in for a very difficult few years, and could be beaten fairly easily by any number of investments. Cash has beaten it handily lately.
The problem with the S&P 500 is that it just isn’t very representative of the “market” anymore. Twenty years ago it may have been but today, you have a choice to invest in large-cap, mid-cap or small-cap companies (while the S&P only includes the 500 largest American companies) or companies based outside the U.S. (S&P 500 is U.S.-only). Large-cap U.S. stocks are less than half the market capitalization available to a U.S.-based investor. And many of those assets you can buy will be only loosely correlated with the S&P.
I just wonder, could the stock prices within the same industry be viewed as substitutes? If so the pain within industry will spread into most firms within it. In that sense Mr. Buffet is lucky or genius since his holdings are private therefore the industry impact is softer and returns could be higher.
Not that I am trying to marginalized his ability to pick value investments.
To paraphrase Garrison Keillor … Welcome to Hedgie Land where all the women are blond, all the men are wicked smart, and everyone’s performance is above average
If people want more information, the arguments of Buffett and Protege can be read at http://www.longbets.org. Long Bets is holding the funds behind this wager (along with many others) until it is resolved.
You can make your own predictions, challenge those of others, or just comment on the ones already listed. Long-term, accountable dialog and predictions are the goals of the site, and there are a lot of fascinating bets beyond Mr. Buffett’s.
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