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.
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.