Friday, April 7, 2017

Warren Buffett’s Bet Shows the Market Wins, Again

Pathways Advisory Group, Inc.
Evon Mendrin, Paraplanner

If there’s one thing that’s been confirmed over and over in my few months at Pathways, it’s the undying belief that markets work. I’ve been baptized in the eternal optimism in businesses and the investment in those businesses as broadly and efficiently as possible.

Warren Buffett agrees – and 9 years ago a great bet was brought forth.

It was 2005 when the first challenge was announced by Buffett – he reminisced in his recent 2016 Letter to Shareholders that he boldly declared the following:

 “I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees.” 

Fast forward to 2008 – a contender emerged, and the heavyweight bout began.

Protégé Partners, LLC came forward – a New York City money management firm that runs funds of hedge funds. In other words, they create funds that invest in other (hedge) funds. Their skill is selecting the best hedge funds available for their investors, rather than running their own. In theory, they select the cream of the crop – able to produce positive returns through any market environment.

In Buffett’s corner is the simple Vanguard S&P 500 index fund. In the opposite corner is Protégé’s selection of 5 funds of hedge funds – the names of the funds not publicized but known by both parties.

The bet was simple – as told on, the host of the bet. “Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.” The stakes, totaling $1 million at the end of the bet, goes to the winner’s choice of charity.

The challenge is, indeed, the challenge of passive investing vs. active investment management as a whole.  Buffett, often called the Oracle of Omaha, has long been critical of the active investment management industry and the fees charged in their services. Passive investors, he argues, will instead enjoy the growth of the market as a whole with minimal costs involved. As he states in his argument on Long Bets,

“A lot of very smart people set out to do better than average in securities markets. Call them active investors.

Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.”

He is especially critical of hedge funds – the supposed cream of the crop. The managers of these funds are supposed to operate at a level above traditional active management – enticing institutional and wealthy sophisticated investors to take the bait.

Nine years into the bet – who is pulling ahead?

As of February 25, 2017, the compound annual increase for the index fund was 7.1%. The collection of hedge funds? Only 2.2% compounded annually. To put that in terms of dollars - $1 million invested in the five hedge fund-of-funds would have grown to $1,220,000. The index fund would have grown to $1,854,000.

While there are 7 months left to the bet, we can assume Mr. Buffett’s charity of choice will be eagerly anticipating the mail come January 1st, 2018. As the Oracle concludes in his recent Letter,

“The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

This bet highlights what we wholeheartedly believe – have faith in the markets. Have faith in businesses. Invest broadly and efficiently, without trying to select or time, and let the markets work for you over time. Focus your energy, instead, on other financial decisions important to your success. Your future self will thank you for it.


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