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Think someone can pick market-beating funds for you? Don’t bet on it…

Image of Warren Buffett

I am not sure what I’d have to be smoking to make a public bet against Warren Buffett in the field of investing. But I am sure a libel laywer would have a view.

So let’s just say Ted Seides was overconfident when he took the other side of a wager against Buffett back in 2007.

The bet? That no investment professional could pick five hedge funds that would beat a cheap Vanguard S&P 500 index tracker fund over a 10-year period.

Warren Buffett has dedicated his long life to becoming the world’s richest man1 through investing. The proof is in the pudding. He has very little to gain from winning this bet – even today his firm is a quasi-active investment vehicle, and he promotes index funds for fun not profit – whereas the downside is a lot of egg on his face. You’ve got to think he was confident.

Cue warning lights.

I mean, making an investment bet against some hypothetically nervy, sleep-deprived, drug-addled Buffett might be conceivable.

But Warren Buffett confidently writing to his faithful shareholders in his annual report that nobody would win such a bet?

Back away slowly, keeping a tight hold of your wallet.

Sweaty Bet-ty

Here are some things where I’d back myself in a bet against Buffett:

  • Who can eat the most vegetables from the salad counter.
  • Who can talk the longest about investing without mentioning American exceptionalism, Benjamin Graham, Coca-Cola, being greedy when others are fearful, or how a farm will be productive for 30 years regardless of the going rate for farms that week.
  • A 100m sprint (no golf buggies or other vehicles allowed).
  • First to find your seat on a commercial flight.

Here are some things where I wouldn’t bet against Buffett:

  • No-limits Texas Hold ’em poker.
  • Who can eat the most hamburger dinners in a row before cracking and ordering sushi.
  • Investing.

Buffett is a stock market genius. Trackers are cheap and their returns trounce most active funds over 10-year periods. Hedge funds are insanely expensive, and even their best managers face a mighty struggle in overcoming the hurdle imposed by the high fees they charge.

Talk about a loaded deck.

Seriously, it’s one thing to get rich selling active management magic that costs your clients 2-and-20.

It’s another thing to actually believe in it.

Fee high foe fun

On a personal level, Buffett says he likes his opponent in this wager. Seides does come across as a decent sort, and I certainly admire the fact that he – as a co-founder of investment firm Protégé Partners – put his money where his professional mouth was.

I mean, with trillions under management for their clients, and millions – if not billions – in the bank, you’d expect a scrum of hedge fund managers would have been falling over each other to put the yokel from Nebraska back in his place.

What a great advert for the hedge fund industry beating Buffett would be! Surely they all jumped at the chance?

Of course not. Hedge fund managers are not dumb.

Seides stepped up though, and you have to admire that. I always have a soft spot for the trooper who volunteers to take the pistol with two bullets from the Captain and heads out into the snow to seek a miracle while the rest of his comrades huddle safely in the bunker.

But where Seides really made life hard for himself in his suicidal bet against Buffett was that he didn’t just pick five hedge funds. He picked five funds of hedge funds.

This means Seides’ selections compounded the high fees charged by hedge funds with another layer of fees on top, from the fund of fund managers.

This is a bit like inviting termites onto your leaking rowboat. Money is soon pouring out of every (mixed) metaphorical orifice.

Lars Kroijer wrote an article for us about fund of fund fees. He estimated that for every $10 of return generated by the underlying funds, the actual investor might get to keep $3.

Staggering. Go check the maths.

Against all odds

To be fair, we must remember that back in 2007 hedge funds as an asset class hadn’t yet wracked up a diabolical decade of market-lagging returns.

They have now. When Pension Partners surveyed the scene in 2016, it found that:

…since the start of 2005, the HFRX Global Hedge Fund Index and HFRX Equity Hedge Index (two investable indices widely used as benchmarks in the industry) have posted negative returns (-1% and -6.4% respectively).

Over that same time period, the Barclays Aggregate Bond Index was up 62.1% and the S&P 500 up 97.6%.

Negative. Returns.

The odds were against Seides. But he might still have had a tiny chance of winning if he’d tried to somehow alight upon those few funds in the $4-trillion industry that delivered decent returns after fees over the past nine years.

However by opting for funds of funds, Seides reinforced that huge cost hurdle by condemning his returns to mediocrity, via five flocks of mutton dressed as lamb.

In his annual letter to shareholders, Buffett reveals the gory results with just one year to go:

Table of hedge fund of fund returns in Warren Buffett's bet.

Table taken from Warren Buffett’s letter to shareholders, February 2017.

Source: Berkshire Hathaway Shareholder Letter 2016

Forget beating the S&P 500 as a group. Only one fund of funds has got within shooting distance of the index, and even it trails it. The rest are woeful laggards.

It’s safe to say that Buffett’s nominated charity can already start to think about how they will spend his winnings.

Buffett writes:

I estimate that over the nine-year period roughly 60% – gulp! – of all gains achieved by the five funds-of-funds were diverted to the two levels of managers.

That was their misbegotten reward for accomplishing something far short of what their many hundreds of limited partners could have effortlessly – and with virtually no cost – achieved on their own.

In my opinion, the disappointing results for hedge-fund investors that this bet exposed are almost certain to recur in the future. […]

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.

Buffett also mentioned that he always recommends index funds to friends, but that only those of modest means and little business knowledge follow up on the idea. The financially successful feel short-changed, and seek better returns elsewhere.

This has been my experience, too. While I’d obviously wish my own friends better, from a societal perspective long may this vanity tax on the rich continue.

Work it out

I happened to see an interview on CNBC with a City professional on Monday morning, after Buffett’s letter had been released.

The gist of the interviewer’s question was that if investing legend Warren Buffett says people should use index funds, then why shouldn’t people use index funds?

To his credit, the Cityboy looked momentarily terrified.

(Note to Ted Seides: When you’re up against Warren Buffett on the subject of investment advice, terrified is the appropriate posture to adopt).

Perhaps remembering who buttered his bread, the sacrificial lamb eventually spluttered back to life. He agreed that trackers were okay for those without financial advice, but that “hard work” and professional expertise would always be able to find you those funds that outperformed.

This is nonsense. The correct statement is they might, but the odds are against it.

Hard work is always trotted out by active apologists, but almost everyone in finance works hard. And picking market-beating fund managers is the same zero sum game that active investing is, only the downside has extra knobs on due to even more fees.

Ted Seides’ superb CV includes Yale and Harvard, time spent working with David Swensen, and experience co-founding a multi-billion dollar investment shop. (His biography also sportingly references his aspirational bet with Buffett.)

By any measure Seides is an accomplished professional. If he can’t find five funds that will beat an S&P Index fund – with $500,000 of his own money on the line – then do you think it’s likely your local financial advisor on the High Street in an office above a kebab shop will do any better?

Buffy the vampire slayer

Warren Buffett is a rare kind of unicorn. Rather than tell you there’s a whole pasture of his type over the next green hill, he advises you to look for a workhorse instead.

Buffett readily agrees that some fund managers will beat the market. Besides himself, he believes that in his lifetime he’s identified – at that start of their careers, when it actually mattered – a whole ten!

He continues:

The problem simply is that the great majority of managers who attempt to over-perform will fail.

The probability is also very high that the person soliciting your funds will not be the exception who does well.

Why bother? Invest passively, and get a market return at the lowest price. By all means pick stocks if you love business and the challenge like I do. But why pay a fund manager to have the fun of delivering a lower return on your behalf?

And whatever you do, don’t pay twice for an active fund of funds.

(A passive fund of funds is a different and vastly cheaper kettle of fish. We approve of those).

  1. On and off. []
{ 21 comments… add one }
  • 1 Mark February 28, 2017, 11:02 am

    The message I take away from Buffett’s bet is not to invest passively, so much as to avoid hedge funds.

  • 2 The Rhino February 28, 2017, 11:18 am

    Is that sub-heading a reference to the macc lads?
    Mighty impressed if it is..

  • 3 Bastiat February 28, 2017, 1:00 pm

    Then you didn’t read the rest of his newsletter because the overwhelming majority of active fund managers also get trounced by passive funds.

  • 4 Michael February 28, 2017, 1:30 pm

    “Fee high foe fun”

    I have nothing to contribute except admiration for that quality pun.

  • 5 Cowboy February 28, 2017, 2:09 pm

    @Michael and some superb poetry from you apparently.

    As for the poor sap on CNBC, I leave that to Upton Sinclair… “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

  • 6 Factor February 28, 2017, 2:17 pm

    @TI “The proof is in the pudding”

    I wince every time I hear/see this – it’s what I call footyspeak, born of the post-match interview! The correct saying is of course, “The proof of the pudding is in the eating”, which makes perfect sense. 🙂

  • 7 IanH February 28, 2017, 2:41 pm

    Thanks for explaining the ‘fund of funds’ aspect. I’d thought Seides had cunningly gone for a global portfolio of funds that worked around Buffett’s rules for the bet and gave him a good chance of matching the market too – I didn’t realise this was doubling the fund managers’ rake-off. What a mug! Was he so confident perhaps that he thought it would make his point even more strongly when he won with this additional fees handicap?

  • 8 dearieme February 28, 2017, 3:00 pm

    “Hedge fund managers are not dumb”: aye, they’re noisy brutes.

    But you’ve made a case for one of them being stupid.

  • 9 mousecatcher007 February 28, 2017, 3:45 pm

    @ The Rhino – Sweaty Betty, eh? We’d best not repeat the lyrics to that in such civilised company as this!

  • 10 Scott February 28, 2017, 4:43 pm

    @Factor – seconded! I expect better from this blog 🙂

  • 11 marked February 28, 2017, 7:55 pm

    So I have wondered if the rockstar fund managers of the world simply get to a point where the money being thrown into their fund(s) get so big they have to be much broader and their strategies have to change/evolve/guess to cope with all that extra money coming in? Over time continuously rolling the dice eventually you’ll get a 1 instead of a 6, but with the herd throwing extra money into the fund manager’s lap aren’t they changing from one die to two dice and trying to get a 12 everytime?

    Not sure. I am thinking of Neil Woodford as I write this.

  • 12 FrugalFox February 28, 2017, 10:03 pm

    @marked that works the same with passive funds I guess. As more and more money goes into the funds they are forced by their nature to buy more and more of a certain share even if it is massively overpriced.
    Its at that point you w(c)ould start being more active and deciding to stop buying certain shares.

  • 13 dearieme March 1, 2017, 4:29 pm

    A Barings prediction from last Spring. They obviously don’t think much of Hedge Funds.


  • 14 dearieme March 1, 2017, 4:30 pm

    Mind you, they don’t think much of US Equities either.

  • 15 Naeclue March 1, 2017, 6:16 pm

    The hedge fund returns do seem very bad. Even if they said they took less risk, evident from the smaller decline than the S&P in 2008, the returns are still poor. Here are the returns for a a lower risk Vanguard 60/40 equity/bond fund (VBIAX):

    year TR
    2008 -22.12%
    2009 20.11%
    2010 13.29%
    2011 4.29%
    2012 11.49%
    2013 18.10%
    2014 9.99%
    2015 0.51%
    2016 8.77%

    Total return 75%. They haven’t even beaten a 60/40 fund!

  • 16 Naeclue March 1, 2017, 6:22 pm

    @FrugalFox No it does not work the same way because passive funds, cap weighted ones anyway, are price neutral.

  • 17 FIREplanter March 2, 2017, 12:03 am

    Somehow I have the idea that this Seides chap is in together with Buffet on this bet, just that they need someone to play the fall guy on the other side to prove their point. Why else would you try to attempt to use a Fund of Funds, with twice the layer of charges to compete with an index fund? Isn’t a single active fund a good enough comparison?? Sneaky but point proven.


  • 18 The Rhino March 2, 2017, 12:37 pm

    @Factor – Note the infamous term can and has been used appropriately in the media, see https://youtu.be/Xhlx43rTs2Q

  • 19 Jeff March 2, 2017, 10:28 pm

    I worked out some rules for selecting actively managed Investment Trusts about 8 years ago. Last time I looked, 8 out of 9 trusts picked this way had outperformed against the appropriate MSCi benchmark, some by a good margin.

  • 20 The Rhino March 3, 2017, 5:47 pm

    @Jeff – might be worth adding your insights to the appropriate greybeard article?

  • 21 Dave C March 3, 2017, 9:57 pm

    So for a new investor who is ready to invest and given the current market conditions. Would Buffet recommend to invest in the S&P using dollar cost averaging now. Or wait for a market correction given its overpriced (Schiller PE is currently 26).

    Feels like this bull could run for ever but then they probably said that in 2000!

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