The bet Buffett made with Protege was that "a portfolio of funds of hedge funds" of their choosing couldn't beat the S&P 500 over a ten year period.
The winner's charity of choice is to receive the $ 1 million.
For background, here's the wording of the specific wager that was made between Buffett and Protege:
"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."
So how are the funds chosen by Protege doing against a Vanguard mutual fund that tracks the S&P 500?
According to this Bloomberg article, the returns since the beginning of the bet were as follows:
Vanguard S&P 500: Plus 2.2 percent return (low-cost Admiral shares)
Hedge funds: Minus 4.5 percent return
That's hardly definitive but, then again, not really surprising consider the difference in fees and other frictional costs.
Most hedge funds are compensated via the '2 and 20' fees. Investors in the fund are charged for 2 percent of the assets each year (management fees) plus 20 percent of profits generated (performance fees).
I happen to find the idea of paying that much baffling but, somewhat amazingly, the frictional costs involved go beyond those fees.
From the Bloomberg article:
In addition to the 2 percent management fee and 20 percent performance fee that hedge funds typically charge, the funds of funds add another layer of fees, on average 1.25 percent of assets and 7.5 percent of any gains, according to data compiled by Bloomberg.
To me, 1 percent seems like a lot.
Buffett and Protege present their arguments for the wager here*.
An excerpt from Buffett's argument:
...passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.
Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor's equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.
A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose...
An excerpt from Protege's argument:
Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional "relative-return" investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls. For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.
There is a wide gap between the returns of the best hedge funds and the average ones. This differential affords sophisticated institutional investors, among them funds of funds, an opportunity to pick strategies and managers that these investors think will outperform the averages. Funds of funds with the ability to sort the wheat from the chaff will earn returns that amply compensate for the extra layer of fees their clients pay.
According to the Bloomberg article, Buffett told Carol Loomis he thought his chance of winning was 60%. So for Buffett this is not exactly the high probability outcome he usually seems to like when putting capital at risk. I'm just guessing but this seems more about a way for Buffett to highlight the extremely high fees that are the norm in the industry.
It's certainly possible the funds that were chosen to compete with the S&P 500 by Protege may, in fact, do better over these ten years in this particular wager. To me, that would miss the primary point.
I think the more important thing to consider is that, with all those costs layered on, the probability of outperformance is not very high on a consistent basis. A large enough sample would likely reveal just that.
Certain funds will outperform, of course, but that a large percentage of funds (or funds of funds) could consistently overcome all those fees and expenses seems improbable at best.
Good luck to those trying to separate the few long-term winners from the rest.
Most investors, on average and over the long haul, will do better with a low-cost index fund.
Adam
* The site is longbets.org. Its stated purpose "is to improve long-term thinking" and is backed by the non-profit The Long Now Foundation.
Buffett's Bet Against Hedge Funds
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