Betting against Buffett: an expensive way to learn a valuable lesson

warren buffett

When the legendary American investor Warren Buffett recently turned 87 he celebrated the milestone as the second richest person in the world, with a net worth estimated to be around $96 billion.  

Buffett’s investment prowess is the stuff of legend, having started his own investment fund at the age of 26 with little more than $200,000, then growing it into an investment powerhouse in Berkshire Hathaway, a company valued at over $560 billion today.

Such has been the impact of the ‘Oracle of Omaha’ on the investing world that there are entire websites, chatrooms and online forums dedicated to discussing his investment approach, deal history and ability to ‘beat the market’ over such a long period of time.

Now in his autumn years Warren Buffett is also one of the world’s greatest philanthropists, reputedly having given away an astounding $35 billion over the past decade. He is also keen to share his investment wisdom with anyone who’d like to know how best to grow their wealth over time.

So how does Buffett, perhaps the greatest active sharemarket investor of all time, think most investors should invest? The answer might surprise some, but in his view:

“By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.  Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb….Those index funds that are very low cost….are investor-friendly by definition and are the best selection for most of those who wish to own equities.”

Walking the Talk

These aren’t just empty words. Buffett has instructed that 90% of his wealth be invested in an index fund that tracks the US S&P 500 sharemarket index upon his death.  

This from a man who has made billions beating the market. What gives?

Well, Buffett knows that you, me and just about every other human on earth can’t, or won’t, be able to invest like him. Partly because we simply don’t have his investment acumen or discipline (he reputedly reads up to 500 pages every day). But mostly because we don’t have his patience and emotional control when putting our hard-earned wealth at risk.

Buffett also has a keen understanding of how most ordinary investors are taken for a ride by the investment industry. His 2005 investment letter contains a two page section titled ‘How to minimize investment returns’ (pages 18 & 19) that outlines how a myriad of industry ‘Helpers’ mostly help separate investors from their full share of returns.

In the letter Buffett wryly notes that“…the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.” Ouch!

The One Million Dollar Bet

Buffett could have let the matter rest with his 2005 letter. However, he was so confident that low-cost index funds would produce superior outcomes for most investors that in 2007 he challenged hedge fund managers to a one million dollar bet.

Hedge fund managers aren’t just any regular investors. They’re the elite. The best and brightest math wizards (‘quants’) and physics PhDs amongst them. They work in secretive firms, continuously churning investment data through proprietary algorithms that inform a bewildering range of trading strategies, often involving derivatives and leverage (borrowed money).

Investors pay handsomely for all this intellectual investment horsepower, often to the tune of 2% per year of funds invested, plus 20% of any performance above an agreed upon mark.  Hey, if you want the best, you gotta pay for the best, right?

Buffett thinks otherwise. He was prepared to bet that over the 10 year period between 1 January 2008 and 31 December 2017, no hedge fund pro could select a set of five hedge funds that would outperform a simple index fund tracking the S&P 500 index of US shares that charged minimal fees instead.

Only one hedge fund manager stepped up to the plate. Ted Seides, a partner with a fund of hedge funds (a hedge fund that invests in other hedge funds), agreed to the bet, in which he would select five hedge funds that together would be pitted against Buffett’s selection, an index-based fund aiming to replicate the S&P 500 index.

And so the bet was formalised, with the loser to donate $1,000,000 to a charity of the winner’s choosing. Buffett picked Girls Inc. of Omaha, a charity dedicated to helping girls navigate gender, economic and social barriers to grow to their full potential.

Not Even Close

It was a tough start for Buffett. The US sharemarket fell 37% in 2008, far more than the collective 24% fall of the five hedge funds. It fell 50% in the first 14 months of the bet. At that point most individual investors would probably have abandoned the market for the safety of cash.

At the three year mark the hedge funds were comfortably in the lead, having only fallen 4.2% versus an 8.2% fall for the index fund. Half way through and it was the index fund in the lead, but only by a nose.

Fast forward to May 2017 and Ted Seides conceded defeat. His selection of hedge funds generated a compound annual return of 2.2% per year, gaining $220,000 in the nine-plus year period, while Buffett’s selected S&P 500 index fund returned 7.1% per year, and would have gained $854,000, a 288% advantage. There was simply no way the hedge funds were going to bridge that gap in the time remaining.

The journey of the S&P 500 index during the course of the bet was certainly not a smooth one, as shown below, but Warren Buffett’s patience enabled him to harness the entrepreneurial drive and energy of these companies to comfortably put the competing hedge funds to shame.

S&P 500 index

Source: The Irrelevant Investor

For all their sophistication and supposed mastery of financial markets some of the best and brightest minds on Wall Street not only didn’t beat the market, they didn’t even get close.

Seides has claimed that part of the reason he lost the bet was because “passive investing is the rage today, and the S&P 500 is the most popular index.”

Buffett has an alternative explanation. The annualised return of the S&P 500 of 7.1% per year through to early 2017 “…is a return that could easily prove typical for the stock market over time.”

Instead Buffett points to the fees levied by both Seides and each of the underlying hedge funds, which he calculated collectively diverted 60% of all gains to the various managers. Or as he put it:

“A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.”

One of the most watched financial bets in history thus comes to a close, with an investing legend demonstrating emphatically that the average investor doesn’t need to have his skills, or find someone who claims to, in order to build significant wealth over time.

All that is needed instead is time, emotional resilience (remember that 50% fall in the first 14 months?) and an aversion for complex-sounding, high-fee investment solutions.

Buffett estimates that the search for superior investment outcomes over simple index-based investments has caused US investors to transfer some $100 billion of their wealth to a whole range of ‘Helpers’ over the past decade.

That’s $100 billion that could have paid school fees, repaid debt sooner or funded an earlier, or better, retirement for very many people. Or donated to a charity looking to empower girls to be all that they can be in this world.

And so to the key take-out Buffett delivers through his near-on ten year lesson:

“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.”

What you do with this sage advice is up to you. Choose wisely.

Harry Chemay is co-founder of Clover.com.au, an automated investment service dedicated to bringing professional investment management within the reach of all Australians using low-cost, passive investment strategies.  

This article should not be taken to constitute financial advice or as a recommendation to invest in any particular financial product. Past performance is no guarantee of future performance.


Also published on Medium.