Index Fund vs. Top Hedge Funds: Buffett Makes A Bet
I instantly dismiss any article that purports to share with me “764 stocks that Warren Buffet would buy”, because I don’t care if some writer thinks he would buy something. I’d only care if Buffett really bought it for Berkshire Hathaway and at what price. This Fortune article “Buffett’s big bet” explores another side of what Buffett believes.
In one corner, you have the Vanguard’s 500 Index fund, ticker VFIAX (admiral shares), which tracks the S&P 500 Index with a lean 0.07% annual expense ratio. (The regular investor shares are VFINX.) It passively invests in small pieces of huge publicly-traded US companies.
In the other corner, you have a group of five hedge funds hand-picked by a big name Wall Street money management firm called Protege (funds of funds, actually). They have worked with folks like David Swensen, and George Soros. Hedge funds are usually only available to individuals with more than $1 million net worth or $200,000 annual income, and they can invest in just about anything. Tiny companies, entire companies, foreign companies, pork belly futures, whatever. However, in exchange you pay big fees: 1% annually for the fund of funds layer, 1.5% annually for the hedge funds themselves, and then 20% of any gains on top of that.
Past performance stats: From its inception in July 2002 through the end of 2007, the Protégé fund gained 95% (after all fees), soundly beating the Vanguard S&P 500 index fund’s 64%.
Now you have to choose which one will have the best returns after all fees over the next 10 years. Which one would you choose? Well, Warren Buffett bet on the index fund, and put up the equivalent of $500,000 at the end of the bet, which would give $1,000,000 to the charity of the winner. He believe that those fees are simply too high to overcome, even with their ability to invest anywhere in the world. But more important of course are either the shame or bragging rights to those hedge fund managers!
Buffett himself assesses his chances of winning at only 60%, which he grants is less of an edge than he usually likes to have. Protégé figures its own probabilities of winning at a heady 85%. Some people will say, of course, that just by making this bet, Protégé has acquired some priceless publicity.
The last part is probably true. No matter what, Protege will make a ton of money in fees at the end of 10 years. If they win the bet, they’ll be on magazine covers and end up even more insanely rich. If they lose, they simply change their hedge fund name and try again.
[CNN / Forbes via Reader Ethan]
June 10th, 2008 at 6:30 am
It’s sickening how hedge funds make people believe they can beat the market because they’re “smarter” than you. It’s even more troubling that people believe them. There’s some innate flaw in human psychology that makes us want to ascribe every good thing to skill rather than chance.
I hope Buffett wins big. I hope it’s not even close. After all, I doubt Protege actually beat the market over the past six years — my guess is they just invested in something riskier than the S&P 500. Emerging markets have zoomed up 300% in the last five years, and mid-caps, European equities and tech stocks have beaten Protege’s number. Luckily for Buffett, in a downturn, these riskier categories will do a multiple worse than the S&P.
Hedge fund guys are a crock. They pretend to be smart but they’re just smooth talkers with nice suits who can do Powerpoint animations and spout a few buzz words. Sure, a few of them will beat the market over time — if 100,000 people flip 100 coins, a few of them will get 70 heads. Then they claim they’re smarter than the rest of us and start up the Medallion Fund or Magellan Fund. But lo and behold, 20 years later the Magellan fund turned out not to be so good at flipping coins after all and now they need your money again.
June 10th, 2008 at 8:16 am
I heard about this! This is actually a tough one. The fees will put the hedge funds at a huge disadvantage, but the lack of diversification for the index will hurt it if the US market stagnates and foreign markets continue to outperform. I think a better bet would have been to put one of Vanguard’s globally-diversified target retirement funds against the hedge funds instead.
June 10th, 2008 at 1:14 pm
This seems like a silly bet for Buffett to make. What does it accomplish if he wins, that hedge funds are bad investments? And even if he does win why wouldn’t someone invest in an index fund versus Berkshire Hathaway? And if he loses, then it will seem like some kind of validation of hedge funds which of course it wouldn’t be. This just seems like a publicity scheme to me.
June 11th, 2008 at 6:30 am
Agree 100% with Kyle. Why’d he chose S&P 500 index? Even if he were to stay with just domestic equities, the Total Stock Market Index would at least have been a more comprehensive choice which also has admiral shares at the low 0.07% ER.
But, who am I to question Buffett?
June 11th, 2008 at 9:22 am
Tom, I think the part you’re missing is that “hedge fund guys” are working to make dollars for themselves.. and they do that very well.
This bet is obviously a marketing ploy. It has made the rounds from Forbes to personal finance blogs. Congrats to Buffet and Protege for excellent results!
June 11th, 2008 at 9:41 am
I’ve followed your blog for a while. Since you are anonymous, and you share everything else (maybe you’ve already discussed this) can you tell us what your current annual salary is, both pre and post tax? If you prefer, your salary history and your wife’s as well?
Obviously this isn’t something I would just ask anyone on the street, but I think it bears knowing on a site where you list all that you have saved. I want to know if it is even a reality for me to do the same.
Thank you
June 11th, 2008 at 11:57 am
My favorite part of this is when they quote Buffet as saying he only has about a 60% chance of winning, those odds not being as favorable as he usually prefers.
June 11th, 2008 at 2:02 pm
Buffet also said just recently that the recession will be long and deep. That was after the Federal government said the economy was growing just under 1 percent for the first quarter 2008. So maybe he doesn’t read the papers? Or maybe he doesn’t have a computer?
June 11th, 2008 at 6:37 pm
This is an interesting bet. For me it doesn’t matter who wins and who loses. This is marketing genius however. For $1 million dollars, these hedge funds are getting their name out there.
At the end of the day, Buffet does not make his money by making predictions. His predictions on how the stock market would be gaining less than the 10% average from the 1960’s to most currently have been pretty terrible. However, he’s been good at buying companeis at bargain prices.
By itself, Berkshire Hathaway is a hedge fund. It buys and sells stocks, businesses, derivatives etc. The publicized thing is that Buffet makes $100,000/year. But how much do the rest of the executives make?
June 25th, 2008 at 12:33 pm
Big deal “Buffet makes $100,000″ a year, he makes a ton on stock gains. You appear to be an educated person so I am sure you knew that. Buffet does make predictions albiet much less risky ones than a hedge fund would be inclined to make. This is evidenced by his recent push of alternatives to petroleum. Correct bet? Probably. Bet? Yes.