Buffett’s bet on index funds

Bankrate Logo

Why you can trust Bankrate

While we adhere to strict , this post may contain references to products from our partners. Here's an explanation for .

Hedge funds are not necessarily all they’re cracked up to be. At least not if you believe Warren Buffett. In 2008 the Oracle of Omaha made a friendly wager with a New York money management firm that a Standard and Poor’s 500 index fund would beat a set of five hedge funds. The New York money managers, Protege Partners, built an index of five funds that invest in hedge funds to compete against Buffett’s entry, Vanguard’s S&P 500 index fund.

The terms of the bet were that each contestant would pony up $320,000 so that a total of $640,000 would be invested in a zero-coupon bond that would eventually be worth $1 million by 2017. The zero-coupon bond hit the million-dollar mark in 2012, Carol Loomis reported this week for Fortune.com.

Halfway through the decade-long wager, Buffett has pulled into the lead, with the index fund up 8.69 percent to the fund of funds’ 0.13 percent, according to Fortune.

From the Fortune.com story, “Buffett pulls ahead in wager against hedge funds”:

… You need to keep in mind that this bet started in the gut-wrenching year of 2008, which left both contenders deep in the red. Buffett, though, was definitely a deeper shade of red:  Vanguard’s Admiral shares — the S&P index fund he’d backed — lost 37 percent in 2008 vs. a 24 percent drop, on the average, for Protege’s five funds of funds.

Fees count, too

While hefty stock market returns will undoubtedly help any stock index fund, low fees on passive strategies often make up some of the gap in returns between index funds and active funds that outperform. Higher annual fees eat into total returns, which means actively managed mutual funds have to actually outperform their benchmarks plus their expense ratio before it begins to pay off for investors.

Similarly, hedge funds come with fees. and they are considerably higher than those of most active mutual funds. Also, a fund of hedge funds has a double layer of fees that has to be overcome before an investor will realize a positive return. On top of that, hedge funds typically charge a hefty performance fee, too.

Here’s another reason why a fund of hedge funds matched against an index fund is not really an apples-to-apples comparison: low betas. Hedge funds have an average beta of 0.5 according to the site Insider Monkey, which tracks hedge funds and SEC filings from insiders and publishes articles about investing.

A beta of 1 means an investment is as volatile as the stock market. A low beta indicates less volatility and risk as well as lower returns. Even if a hedge fund generates enough risk-adjusted return to overcome fees, “They may still underperform the market because they partly hedge their bets. They are less risky than index funds are, but Warren Buffett’s bet ignores that risk. Over a 10-year period it is more likely that the S&P 500 index will increase in nominal terms. So, funds of hedge funds have three handicaps they have to tackle to beat passive investing: hedge fund fees, (fund of funds) fees, and their low betas,” according to the Insider Monkey story, “Investing in funds of funds is a dumb idea.”

“I like Buffett’s chances of success simply because every single year, his fund only has to overcome a fee of 0.05 percent — assuming he is using Vanguard 500 index Admiral — as compared to the multitier and profit-sharing component of the hedge funds, which could be as much 3.25 percent in management fees and profit-sharing components,” says Robert Laura, president of Synergos Financial Group in Howell, Mich.

“The other thing I will say is that fancy or sophisticated strategies aren’t always better. Many times, the rules of life apply to investing as well — like KISS — keep it simple, stupid,” he says.

So why would anyone invest in anything but index funds? While there are many good reasons for some people, in some cases investors can be too opportunistic, says Julie Murphy Casserly, CFP professional, founder and president of JMC Wealth Management in Chicago.

“Particularly when taxes got increased with all those employed, incomes are not rising, people are looking for things to out-produce return for them, particularly because most people are not willing to reduce lifestyle and save more,” she says.

Do you have any thoughts on the bet?

Follow me on Twitter: @SheynaSteiner.