Nearly 10 years ago, iconic billionaire investor Warren Buffett took what seemed like a contrarian bet for a professional stock picker.
He bet any comer that a simple, low-cost investment in the S&P 500 would beat a hedge fund strategy over 10 years. On the line was $1 million, to be paid to a charity of the winner’s choice.
Buffett won that wager handily, ending the ninth year of the bet up 85.4% vs. 22% for a collection of five hedge funds. The hedge fund manager who took him on has thrown in the towel, conceding that a passive investment in the stock market was unbeatable.
In annualized terms, Buffett’s low-cost index fund investment grew by 7.1% per year, compared to 2.2% for the hedge funds.
The losing hedge fund manager, a remarkably good sport named Ted Seides, later wrote a footnote on the loss in the form of an online column. Essentially, Seides wrote, Buffett’s win was more about luck than skill.
In the wide-ranging mea culpa, Seides blames various “unexpected” outcomes for the failure, including his own apparent failure to foretell the future:
When we made the bet in 2008, the S&P 500 traded at the high end of its historical range. Probabilities strongly suggested the S&P 500 would generate low returns in the future, which would have helped the relative performance of hedge funds. But the S&P 500 defied the odds and rewarded investors with a historically normal 7.1 percent nine-year annualized return.
Nevertheless, farther down in the same column he makes the opposite argument:
My guess is that doubling down on a bet with Warren Buffett for the next 10 years would hold greater-than-even odds of victory. The S&P 500 looks overpriced and has a reasonable chance of disappointing passive investors.
And that’s the problem with active investment thinking, namely, the desire to have it both ways. Apparently, the stock market surprised everyone by rising for nearly 10 years, yet somehow stocks won’t do the same thing in the next 10 years.
In fact, the stock market has long demonstrated the ability to surprise investors who fail to have the foresight of owning a crystal ball. That is Buffett’s fundamental point.
Over long periods of time, stocks go up in value. Sometimes they go up when markets are “overvalued” and look expensive. Sometimes they go up after markets have declined.
Stocks also go down. In the case of Buffett’s bet, the stock market stumbled right out of the gate. Stocks fell 37% in the first year of the wager, in 2008.
The hedge funds lost ground, too, just not as much. The collection of five funds put forward by Seides lost 23.9%. In the ensuing years, of course, the Buffett index fund approach crushed the hedge funds, despite 2008.
That relative early “win” by the hedge funds in a down market might be construed as an argument for using them. After all, the idea of hedging is to lose less in a bear market and to participate in a bull market.
If you’re already rich and living off your bond income, I suppose that the idea of limiting losses while getting a portion of the gains is attractive. But not at the cost of the outrageous fees charged by hedge fund managers.
Cheap and effective
If you want to diversify a portfolio, there are much cheaper and equally effective ways to do that. Owning low-cost index funds that track the bond market alongside stocks, for instance.
A risk-adjusted portfolio of index funds provides the upside of the broad stock market, exactly as Buffett proved in the hedge-fund wager, while offsetting the risk of rash choices.
Seides talks about emotional risk as well, to his credit:
The S&P 500 index fund fell 50 percent in the first 14 months of the bet. Many investors lacked Warren’s unparalleled fortitude, and bailed out of the markets when the pain became too severe. An investor who panicked and only later re-entered the market would have found that his bank account at the end of the bet was a lot smaller than a hypothetical account in which he earned the index-fund returns for the whole period.
He’s right. The error, however, is believing that a costly, actively managed hedge fund approach is the best way — or even a good way — to reduce the emotional risk of long-term investing.
A low-cost portfolio of index funds would do it, too. If rebalancing in a volatile investment market is beyond your abilities, perhaps occasional help from an advisor is warranted.
Nevertheless, betting against stocks for long periods is usually a fool’s errand. The next 10 years may or may not provide the evidence, but we doubt there are any hedge fund managers raring for a rematch with Buffett.