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Buffett's Big Bet
Warren Buffett recently bet an ambitious hedge fund operator $1 million that they won't beat the returns of S&P 500 after their extremely hefty fees are accounted for. Buffett claims investors will do as well with a no-load index fund over the ten years of the bet. He has long been critical of the performance claims of hedge funds, and his bet is intended to put his money where his mouth is.
Details here. Of course, my money is with Buffett. Even if he doesn't win the bet he is correct about the advantages of index funds. The academic research on this topic is voluminous and the lesson is straightforward - mutual fund managers don't beat the market on average. Note that this doesn't mean the market is perfectly efficient but it does mean that *you* are unlikely to beat the market. For more see my earlier post and also one of Tyler's.
Posted by Alex Tabarrok on June 9, 2008 at 02:39 PM in Economics | Permalink
Comments
But I'm special! I will beat the odds!!!!!
Posted by: GU at Jun 9, 2008 2:49:09 PM
the hedge fund people should invest all the fund's money in berkshire hathaway.
Posted by: ryan at Jun 9, 2008 2:55:14 PM
Buffett himself is only 60% certain that he will win.
If the hedge funds were limited to long US S&P stocks, then it would be a much better bet.
A hedge fund could pick alternative investments and assuming that their returns are greater then the S&P, easily beat the index less expenses.
Overall, you have to like Buffett's bet, since the expenses are a difficult hurdle. This will be an interesting argument for passive investing. University trust funds have been on a hot streak, and it will also be interesting to see how they do this year. Their fiscal year is June to June. One interesting thing about them is that, in theory, they have a much longer investment horizon then individuals, but if they take a major haircut, they will be under the same enormous pressure that all other asset managers face
Posted by: ziggurat at Jun 9, 2008 2:59:18 PM
hedge funds =/= actively managed mutual funds.
Hedgies have vastly more options than a mutual fund manager does. I wonder what the data from that fund-of-fund article showed... but I'm too lazy to check.
Posted by: anglo-burgundian at Jun 9, 2008 3:03:13 PM
I doubt Berk's return on assets exceeds that of an index fund. Levered up (cheaply due to insurance in Berk's case) corporate bonds can beat S&P index fund returns.
Posted by: nelsonal at Jun 9, 2008 3:03:33 PM
The extensive research you reference is with regard to mutual fund managers, as you say. This bet is with a hedge fund manager. Research regarding hedge funds' under/over performance is far less voluminous, straightforward, or decided.
Posted by: Paul at Jun 9, 2008 3:04:07 PM
So, for years, I've heard that "no-load mutual funds" or low-fee S&P Index funds are the way to go for long-term investments, but in the limited research I've done, I haven't found a very efficient way of finding these (or at least finding the funds with the "lowest" fees). Moreover, how would I go about purchasing them? Surely not find some financial planner and say, "I want to make the most money I can while paying you the least I can"?
So I guess I'm looking for advise from some more experienced investors. Is an E-trade account plus a Vangaurd S&P Index the optimal solution here?
Posted by: mravery at Jun 9, 2008 3:05:09 PM
Alex -- I enjoy your comments, but doesn't your post in this case (and Buffett's bet, for that matter) essentially ignore the issue of leverage?
The Vanguard fund is entirely un-leveraged. Even if all the hedge funds did was invest in Vanguard and leverage up 50% -- for most ten year periods they would still beat the Vanguard(even after interest and fees) -- although occasionally they would go bust.
And comparing these assets on an unleveraged basis makes no sense. It's like real estate -- who ever bought real estate without debt? Similarly, one of the main points of hedge funds of funds is that they are *meant* to provide sufficient diversification to safely enable more leverage.
Now, I still agree with Buffett and you that if these were mutual funds, Vanguard will win. But leveraged hedge funds -- unlikely?
Thanks
Posted by: midas at Jun 9, 2008 3:15:00 PM
mravery,
No need for an E-trade account. You can set up an account with Vanguard directly.
Posted by: Bernard Yomtov at Jun 9, 2008 3:19:23 PM
Hedge funds charge very high fees; to beat the S&P index after fees means they have to beat the index by a lot, before fees. A tall order.
On the other hand, hedge funds are free to invest in non-US stocks, or any asset class anywhere in the world. The US dollar exchange rate will heavily influence the outcome of this bet. For the last few years, you could have handily beaten the S&P 500 by investing in, say, Canadian T-bills.
A knowledgeable individual investor certainly could legitimately aspire to beat an index fund or (especially) a mutual fund manager. You don't subtract management fees, you're free to be as contrarian as you like, you can use flexible strategies and adapt quickly, and you can have a very patient long-term outlook. Mutual fund managers face tremendous pressure to be average: being prematurely contrarian, even if they're right in the long term, carries substantial career risk as they're forced to sell assets to meet client redemptions. Many mutual funds are in effect index funds of sorts in disguise, with a fee deducted.
Posted by: at Jun 9, 2008 3:21:58 PM
mravery:
morningstar.com
Posted by: meter at Jun 9, 2008 3:33:20 PM
Given a probability k, the hedge fund managers should be able to invest in the index and sell a very out-of-the-money option to beat Buffet with probability > k.
(c.f. recent work by Young & Foster such as http://www.bepress.com/ev/vol5/iss2/art1 or http://www.nuffield.ox.ac.uk/economics/papers/2008/w1/HedgePaper2MAR08.pdf)
Presumably Buffet is actually betting on the hedge fund managers being greedy as opposed to betting on their outperformance per se.
Posted by: Daniel at Jun 9, 2008 3:44:38 PM
Alex,
Your comment would frustrate Buffett and Munger, who have spent plenty of time arguing against efficient market theory.
The reason that Buffett is a safe bet is not because markets are efficient, but because over long periods of time, the inefficiencies that active managers can exploit tend to get washed out by the additional transactions costs and management fees demanded by active managers.
If you're the active manager and you follow the rules laid out by Graham, Buffett, and Munger, you're actually quite likely to beat the markets over a long period of time.
Note that this doesn't mean that I disagree that index funds are the best investment for most people! Most people don't have the time, interest, or personality required to be good active managers of their own money.
Posted by: Michael F. Martin at Jun 9, 2008 3:45:31 PM
Buffett has, IMO, a huge advantage in that the FoF will have two layers of fees, most likely both at least "2 and 20": the hedge funds that the FoF invests in, and the FoF itself. Using a simplified model with no "hurdle" (some funds must clear the S&P or another benchmark in order to earn their incentive fee) with one hedge fund and one FoF investing in it both set up with 2/20 structures, a gross 20% return by the HFs invested in by the FoF only produces a 9.2% return to the investor in the FoF. Because of that fact, the underlying HFs invested in by the FoF have to beat the S&P by a significant margin. It's possible, but it's tough.
Posted by: Kyle S at Jun 9, 2008 3:47:49 PM
The issue I'd worry about is that the bet is something that the manager will want to win. One million might not be that big a deal in and of itself (and if it were, watch out) but the publicity involved in winning would be worth a lot. Thus, the issue is that the manager may decide that it is in his interest to take large risks in the final year, betting on things enough to squeak past the S&P at the buzzer if things are remotely close and he's losing, or playing it very conservative at the end if he is winning. Matching the S&P to guard against its movements is easy enough, and you might not have to be all that good to be a favorite if you take that approach.
Posted by: Zvi Mowshowitz at Jun 9, 2008 3:51:02 PM
Alex,
On rereading your post I see that you probably don't disagree with anything that I wrote. Sorry for the confusion on my part.
Posted by: Michael F. Martin at Jun 9, 2008 4:04:39 PM
Michael,
If it's so likely that you can beat the market by following some rules, why do over 90% of all mutual funds underperform the S&P 500 over long periods of time? Are all their managers incompetent, or perhaps lacking in time, interest, and personality?
Posted by: Andy at Jun 9, 2008 4:13:04 PM
Along the lines of what Midas was pointing out:
Personally speaking, it's not enough that the hedge fund outperform the index fund less h.f. fees. The hedge fund would have to beat it handily to compensate for additional risks inherent with leveraging strategy.
Posted by: meter at Jun 9, 2008 4:16:03 PM
Talk about a conflict of interest!
Posted by: anon at Jun 9, 2008 4:23:32 PM
It seems like the hedge fund has an advantage in that if at any point during the bet they are winning sufficiently they can just invest all the money in an S&P index fund to maintain the lead the rest of the way. (By winning sufficiently I mean that their fees for the rest of the year are already covered.)
Posted by: Jeff at Jun 9, 2008 4:25:24 PM
Hey guys.....the $1 million rounds to zero with hedgies/Buffett. They each put up $320k in zero coupon bonds to fund the $1 million payout.
The bet won't influence the hedge funds in any respect. Just buying the S&P with leverage isn't necessarily a winner either. Leverage costs money and bites you badly on the way down. Not to mention trying to overcome the fees.
It isn't all that complicated, it's just a simple bet.
Buffett says that his chances are 60% of winning (but he tends to be very conservative)
The hedge fund guy thinks he has an 85% chance of winning.
Posted by: ziggurat at Jun 9, 2008 4:48:59 PM
I am a little surprised that there was so much speculation on here regarding terms and conditions of the bet, since they are covered in detail in the article, including the magnitude of expenses.
Posted by: ziggurat at Jun 9, 2008 4:52:36 PM
There are multiple ways to achieve leverage; Vanguard essentially becomes levered if the companies it owns are levered.
Posted by: Sean at Jun 9, 2008 7:06:40 PM
Michael Martin has a good point. This can't be a bet by Buffett in favor of EMT, because Buffett wouldn't exist in an efficient market and he knows it.
Posted by: Bernard Guerrero at Jun 9, 2008 8:46:45 PM
"This can't be a bet by Buffett in favor of EMT"
It is more of an argument regarding the headwind of investment expenses. Per Buffett, in aggregate, investment expenses eat up a substantial portion of all corporate profits. If you use a long term return of 9%, inflation of 3%, investment expenses can easily eat up 2 or 3 percent of the real 6% return.
You can use whatever figures seem appropriate (move all my assumed figures up or down to fit your view), but I haven't even considered taxes. After everyone gets their taste, there isn't much left for the investor. If you compare total 'friction' from active management, which include explicit fees as well as all sorts of minor transaction costs, a substantial portion of public company profits are consumed by the 'helpers' who by definition, in aggregate, beat the average.
Posted by: ziggurat at Jun 9, 2008 10:13:51 PM
