Dice

Buffett's $1 Million Bet and Why You Should be an Indexer

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Back in 2007, Warren Buffett made a $1 Million bet with Ted Seides from Protégé Partners that a simple index fund will outperform hedge funds over the subsequent 10-year period. We have covered the story of this wager over time here and here. Armed with the Vanguard S&P 500 Index Admiral Shares Fund (VFIAX), Mr. Buffett has dominated his hedge fund colleague by double digits in terms of total return. As of the end of 2016, Mr. Buffett’s simple index fund had returned 85.4%, which included the substantial market contraction of 2007 and 2008. How about the basket of funds of hedge funds hand selected by Mr. Seides, which encompass hundreds of individual hedge funds? 22%.[1]

Mr. Buffett has long shunned the hedge fund industry as providing value to investors. At Berkshire’s Annual Shareholders meeting last year Mr. Buffett stated, “there’s been far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities.”[2] In his 2016 letter to shareholders, Mr. Buffet gave a simple explanation for why he was willing to take the bet, tapping into the 1991 sentiments of Nobel Laureate Bill Sharpe in his article The Arithmetic of Active Mangement:

“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 passive investors.”

Taking his explanation further into the realm of hedge funds:

“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 fund than a group of funds of funds.”

Many of the remarks Mr. Buffett made in his annual letter to shareholders were similar to the arguments IFA has been making for almost two full decades. When speaking about random chance, Mr. Buffett stated:

“If 1,000 managers make a market prediction at the beginning of the year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.”

And for the institutional investors and high net worth investors, this is a worthy read:

"Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion. I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant....  Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion may be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: “When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”

Providing his final thoughts on the topic of active managers, Mr. Buffett stated:

“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.”

As Fred Schwed Jr. most eloquently said when highlighting the very same reality of the active investment industry, “Where Are the Customers’ Yachts?”

With 2017 being the last round of the battle, Mr. Buffett is up by approximately 63% in terms of total return. What would need to happen in order for Mr. Buffett to end up losing?

Assuming Mr. Seides’ portfolio of funds of hedge funds continue their average performance over the last 9 years (2.20% annualized return), they would end 2017 with approximately 24% in total return. Mr. Buffett would need to see a drop in the S&P 500 by more than 61% in order to wind up on the losing end.

Just to put this into some perspective, we have never experienced a calendar year going back to 1928 in which the S&P 500 lost more than 61%. Not even in the Great Depression or the last financial crisis we experienced in 2007-2008. If we look at monthly rolling returns, the worst 12-month period for the S&P 500 was from July 1931 to June 1932 where the S&P 500 lost -67.57%. During the 2007-2008 financial crisis, the worst 12-month rolling period return was from March 2008 to February 2009, where the S&P 500 lost -43.32%.

So what are the odds that Mr. Buffett loses? We would need to see a market event that has only happened once in the last 89 years. Assuming the monthly returns of the S&P 500 are normally distributed (not quite, but close), we would need to see an event about 4 standard deviations (one standard deviation has been 18.88% over the last 89 years with an annualized return of 9.74%) on the downside, which has a 0.1% chance of occurring just by random chance. And of course, in such a market, we would not expect much better returns from the hedge funds. Could it happen? Of course it could, but the odds are heavily stacked in Mr. Buffett’s favor, once again proving his simple brilliance as the Oracle of Omaha.

Lastly, Mr. Buffett provided praise to Vanguard founder John Bogle. In his letter he stated:

“If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing—or, as in our bet, less than nothing—of added value.”

By the way, here is Jack Bogle's statue on the Vanguard campus, with Jack standing in front of it:

Image
Source: bogleheads.com

And finally, we hope that someday Mr. Buffett will visit IFA.com and see the benefits of diversifying into indexes beyond US Large companies like we see in the S&P 500. We think he would find this chart and the many others on IFA.com very enlightening:

 

 


[2] Friedman, Nicole. “Only a Market Crash Can Stop Warren Buffett From Winning This $1 Million Bet.” The Wall Street Journal, February 23, 2016. https://www.wsj.com/articles/only-a-market-crash-can-stop-warren-buffett-from-winning-this-1-million-bet-1487851203