Lessons to learn from Buffett's $1 million bet

Warren Buffett needs no introduction. He has outperformed the market for a very very long time and has become one of the richest people in the world. He doesn't keep any secrets either. All his advice and strategy is out in the open for you to follow it. But while he has made his fortune through value investing, he acknowledges that value investing aka as stock picking is not for everyone. In fact he encourages investing in low cost index funds. He wrote in the 2016 annual shareholder letter

My regular recommendation has been a low-cost S&P 500 index fund

He had publicly stated in 2006 itself that he is willing to bet $500,000 that over a period of ten years, an S&P Index Fund would outperform a collection of hedge funds.

An index fund is a no brainer. Instead of picking individual stocks and trying to outperform the market, indexing is based on the premise that just buy the whole market. It mirrors the performance of the market. It is also low cost as it charges only a very small annual fee. After all there is no brain power involved to command fees. All that is needed is to copy the changes in market index.

Hedge funds on the other end is an epitome of active investing. Hedge funds typically employ the best and brightest minds in finance. They have hundreds of analysts and traders working for them. They can also employ various strategies, including going short on the market. Hence the name hedge fund. No Wonder they command very high fees for all this brainy activities. Usual is "2 and 20”, meaning 2% management fee and 20% performance fee (i.e., they take 20% of realized profits).

For several months, no one responded to his challenge. But towards the end of 2007, Ted Seides of Protégé Partners accepted his challenge and this is how the bet was worded

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.

Now hedge funds are also managed by humans and it helps to diversify. So instead of putting all his eggs in one basket, Ted Seides created a diversified basket of 5 hedge funds, with five different strategies (quant trading, long-short, macro, etc.) Buffett later wrote in his annual shareholder letter

Essentially, Protégé, an advisory firm that knew its way around Wall Street, selected five investment experts who, in turn, employed several hundred other investment experts, each managing his or her own hedge fund. This assemblage was an elite crew, loaded with brains, adrenaline and confidence. The managers of the five funds-of-funds possessed a further advantage: They could – and did – rearrange their portfolios of hedge funds during the ten years, investing with new “stars” while exiting their positions in hedge funds whose managers had lost their touch.

It did not start well for Buffett. By March 2009, the S&P Index was down 54%. This is how it appeared at the end of 2008 and then between 2009 to 2017. (Chart source: Berkshire Annual Shareholder letter)

However the market recovered in 2009 and ended up positive in all the subsequent years. The hedge fund managers were in their quest to beat the market, going in and out of their positions, amplifying returns using leverage etc. and in doing so, they made many mistakes. The end result: they all strongly underperformed the market.

  • The S&P 500 Index Fund generated 3.47x higher return than the top hedge funds. Absolute return of S&P over the 10 year period was 125.8% vs 36.3%
  • Hedge funds suffered hugely on account of fees as 60% of all gains achieved by the hedge funds were deducted for the fees. But the hedge funds underperformed the S&P 500 Index Fund even on a gross level (before the fees).

The lessons are not hard to guess

  • It is very tough to beat the market. Even for the best and the brightest of the minds working full time as a team with a highly incentivized fee structure motivating them to beat the market.
  • Trading costs and advisor fees eat away your returns. The more actively you trade, higher the trading costs. And more importantly, higher the possibility of making mistakes.
  • Passive indexing is the best choice for most of the investors. If you just manage to get the market returns through simple indexing, you will outperform most of the investors including the brilliant and the brainy toiling for alpha. Buffett is not saying that no one should pick stocks. If you have the time, knowledge, desire and discipline to do it properly, by all means do it. But most people don't qualify on all these parameters.

Fun Fact

Warren and Ted each funded their $500,000 portion by purchasing $500,000 face amount of zero-coupon U.S. Treasury bonds, costing each of them $318,250 – with the $500,000 payable in ten years. These bonds implied 4.56% interest if held to maturity. That was supposed to be lower than the S&P returns over the next 10 years and also the hedge fund returns. But within 5 years, the bonds had achieved ~95% of their maturity value due to fluctuation in price of bonds on account of changes in interest rates and other factors. Both realized that there was no point holding the bonds for another 5 years for the remaining 5% of gains to make it 1 million. So the bonds were sold and 11,200 Berkshire shares were bought in 2012, with the understanding that if there is any shortfall, Warren will make up the difference so that final maturity value is 1 million USD. By end 2017, those Berkshire shares were valued at $2,222,279, far more than the original target of 1 million dollars. The CAGR over the 10 years was ~21%! Compared to ~8% of S&P and less than 3% of the hedge funds basket. 21%+ CAGR was achieved with just 2 decisions over 10 years and doing nothing in between.

The Rule: How I beat the odds in the Markets and in Life-and How you can too

Larry Hite is regarded as one of the forefathers of systems trading. He grew up as a dyslexic, partially blind kid, facing failure and struggle at every corner. Despite such background, he went on to found and manage, Mint Investment Management Company which at its time became one of the most profitable and largest quantitative hedge funds in the world. In 1990, Jack Schwager profiled Larry in bestselling book, Market Wizards.
It is a fascinating account of someone embracing his fears, frustrations, self-doubt and how this led him to accepting markets as they are. In fact, his familiarity with failure helped him manage risks better and become successful in markets.
There are some key lessons we can imbibe from his life and his market successes. Read on.

Create a system that you can put on auto pilot

At one time, due to an error of judgement made by his investing partner, Larry incurred serious losses and went into debts. He says

I looked at my debt and decided to go back and do what I really liked. I wanted to create an improved trading system that would remove human discretion entirely.
In due course he precisely did that, and he goes on to say

We all signed a written agreement that none of us could countermand the system. It was liberating to let go. I was driven not so much by greed as by laziness. I wanted money to work for me, not the reverse. My goal was to create a system I could put on autopilot so I didn’t have to anguish myself over the ups and downs of the market. This way I could sleep at night, and even better, make money while I was sleeping.

Markets are not efficient and trend following will never really die

Larry says,

Trendfollowing will never really die since there are very few people who are not afraid of losing.
Let that sink in. Much like Warren Buffett, Larry doesn’t believe in efficient markets and says

Efficient markets don’t exist and never will as long as humans are playing the game with greed and fear in a tug of war. What makes this business so fabulous is that, while you may not know what will happen tomorrow, you can have a very good idea what will happen over the long run. I don’t make money because I know anything. I only make money because I do what the market tells me to do.

You have to be comfortable with small losses while managing risk all the time

Quantitative Investing is a business. Losses are cost of doing business. Larry says

All major fortunes are built on a lot of small losses, which pave the way to big wins and success. I failed so often and so badly that I learned to get comfortable with it as a variable. Because I’d been a poor athlete and bad student, it never surprised me that I would lose. I would quickly accept it, fold my cards, and move on to come back to play another day. I recommend you practice losing money. In the long run, that will help you win big. If you are not comfortable with accepting small losses frequently, you should not invest on your own particularly in quantitative, trend following strategies.
Larry’s system,was based on controlling his risk to the downside so that he never loses all of his capital. He says
You can’t completely control outcomes. But you can control two things for sure. The odds of the bet you take, and the risk you take. If you keep placing good bets, over time the law of averages will work for you. If you keep placing bad bets, over time the law of averages will work against you.
His failure helped him win big. How?

I always expected to fail big. Solution? I engineered my actions so that a failure could not kill me. I won because I always expected to lose.
That may sound paradoxical, but is the single most key ingredient to success in investing using any kind of method. 

Backtesting is important 

Now, obviously, just because you get something right in the past doesn’t mean you will get it right in the future—historical testing has its flaws. Just the same, these simulations were highly valuable because using real market conditions—even in the past—gave us far better information than hypothetical scenarios of us sitting around the office guessing.

Drawdowns are a feature and not a bug

Based on Larry’s experience in running trend following strategies successfully, he makes it clear that

Be prepared to lose roughly the size of your annual return. For example, a strategy with a 10 percent return over time should be expected to suffer at least double the annual return in a 20 percent drawdown—so a strategy with a 30 percent return over time should be expected to suffer a 60 percent drawdown.