Even people not involved in the world of finance know the name Warren Buffett. His name has become synonymous with wealth and success, particularly when it comes to stock picking.
People less familiar with the man, the myth, the legend, may not know about his long running bet. About nine years ago, Warren Buffett made a bet with a money manager at Protégé Partners, an asset management company, over what investments would perform better over a 10-year period. Protégé chose to bank on a select group of hedge funds, namely 5 funds of hedge funds whose average performance would be his benchmark. This funds of funds approach meant that Protégé was effectively betting that the average of 100 hedge funds would beat the market average. Buffett, alternatively, bet on a low-cost S&P 500 index fund run by Vanguard. With each side wagering $500,000 on the final outcome, this has come to be known as “The Million-Dollar Bet.”
Before talking about the results, lets examine the philosophies at play. I would consider it to be the traditional method of investing verses the new school of investment management. It used to be that stock-picking was the only way anyone invested in the stock market. Whether you were doing things yourself as a day-trader or having someone else manage your money, it was in Coca-Cola or Yahoo or IBM or Microsoft, etc. People gathered around the water coolers to talk about sports, politics, and how specific stocks and companies were performing. Hedge funds were a special category, charging more money for the promise of even-greater returns than their peers. Because hedge funds are more actively engaged in trying to beat the market, they have been more expensive with much greater volatility. If you won as a hedge fund, you won big. If you lost, you lost everything (or almost everything).
Fast forward to the recent century and the advent of indexes and mutual funds. Their model is that, instead of trying to beat the market, they will simply be the market and take what that gives them. Instead of trying to predict where the market will go or which companies will do better than others, index funds simply try to mirror which companies belong to which index at any moment in time, such as the S&P 500 or the Russell 2000. Mutual funds are a middle ground between index funds and stock picking, where they will invest in dozens, if not hundreds, of companies, but not limiting them to mirroring any one index. Because of their scale and passive mentality, index funds and mutual funds tend to have low fees, with some even charging no fees to invest in them.
Now to the bet, whose results I took from Fortune magazine. We are nine years into this bet, and after nine years the index fund has increased an average of 7.1% each year, compared to the fund of funds averaging 2.2% per anum. To bring the point home, that means that if both parties invested $1 million, Buffet would have made $490,000 more than Protégé, while doing a lot less work and paying somewhere between $200,000 and $300,000 less in fees.
The moral of the story is this; it takes a smart manager to beat the market, but it takes a really smart manager to beat it after fees. With the market representing all invested capital, if passively managed assets represent the market average, then all actively managed assets will meet that average, exceed it, or fail to meet it. Once you add fees onto those returns, how many managers will still have managed to beat the market? Passively managed investments are a way for people to grow their wealth while controlling their risks more effectively and reducing their overall cost of investing. No one knows which way the market will turn or which companies will light up the Dow Jones, but if you are invested in the overall market you will save money in fees with a much lower risk of losing everything.