A Lesson From Buffett’s $1 Million Bet – Hedge Fund vs. S&P Index Fund

Buffett's Hedge Fund Bet

Back in 2007, America’s most successful investor, Warren Buffett, claimed that you can’t outperform the S&P 500 by investing in a hedge fund.

Buffett was so confident in his prediction he was willing to to offer $1 million to charity if any hedge fund manager could outperform his strategy of buying and holding a low-cost S&P Index Fund.

Initially no one took Buffett up on his challenge. Finally in mid 2007, Protégé Partners LLC took the challenge.

After much negotiation, the two parties agreed to a 10 year time frame to cover all types of markets. Buffett’s hedge fund bet started on January 1, 2008 and will end December 31, 2017 (just three more weeks from the time of this writing). Whoever wins the million dollars will have it donated to charity.

Buffett, has long argued that the fees hedge funds command are onerous and to be avoided. Buffett has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protégé has selected.

Nine Years Later Buffett’s Hedge Fund Bet Is Miles Ahead

Nine years into the bet we find that Buffett’s S&P Index Fund is up 85% and the hedge funds Protégé Partners selected averaged only 22%.

The details of the trades are kept private, but I’m willing to bet, that even if you add back in the costs taken out by the hedge fund managers (meaning there are no fees whatsoever), their funds will still not beat the S&P 500 Index Fund. If that is true, than it’s not a matter of “costs” that keep hedge funds from beating the S&P 500 Index Fund, it’s their poor “returns” and poor managers that can’t overcome the costs.

I’ll use my own Index Trading Strategy as an example. I charge subscribers a small annual fee to follow my trades. Those investing $10,000 will incur a 2% annual subscription fee. Investors have to do their own trades. A hedge fund on the other hand will do the trades for you at a 2% annual management fee PLUS 20% annually on any profits.

If Warren Buffett is right about fees, than my Index Trading Strategy should underperform the S&P 500 Index Fund.

I started my portfolio back on January 1, 2009 (one year after Buffett started his). If I was to deduct 20% of any profits (like hedge funds do), my portfolio still gains 914.58% over 7 years! That’s 15x better than Vanguard’s S&P Index fund.

The lesson here is that costs can be detrimental to returns if the returns can’t beat an S&P Index Fund in the first place. However, if returns are great enough, and you can still beat the S&P 500 Index Fund even after high costs, than the high costs are justified and are not something to fear.

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