Buffett shows us why ETFs are worth the bet

What is more profitable? Holding a low-fee broad-based ETF for 10 years, or having your money invested with a high-fee hedge fund for 10 years?

Warren Buffett was confident he knew the answer but wanted to make it crystal clear to all.

So, in 2007, Buffett made a bet with Ted Seides of Protégé Partners, that a low-cost index fund would outperform a hedge fund over a 10-year period. The bet was for $1m, with the winner donating the money to the charity of their choice.

Buffett’s main reason for the bet was to show that excessive fees negatively impacted performance, and he wanted mum and dad investors to realise that they would be better off investing in a low-cost index fund (such as a broad-based ETF).

Hedge funds were infamous for charging fees known as ‘2 and 20’. This means that investors are slugged with a 2% management fee, plus a 20% performance fee for any increase in the value of the portfolio over a set hurdle.

Charlie Munger said, ‘You ask a hedge fund operator why they charge 2 and 20, and they say, 'because I can't get 3 and 30.' It's not about thinking what is fair and right, but merely how much can I get? It's a ghastly culture’.

The Contest

To begin the contest, each side had to first choose their funds.

Buffett chose Vanguard’s S&P 500 index fund, which fully represented the broader US market.

Protégé Partners chose an amalgamation of five hedge ‘fund of funds’, that together owned stakes in more than 200 hedge funds.

The battle began on 1 Jan 2008, which coincidentally was also the time the market started tanking due to the GFC.

As a result, the first year was not a great one for the index fund, with the S&P 500 dropping 37%, compared to a drop of just 24% from the hedge funds.

However, this initial setback was only temporary as the Vanguard S&P 500 index fund outperformed the hedge funds in each of the next nine years.

The victory proved decisive for the index funds which returned on average 7.1% p.a. for the 10-year period, whilst the hedge funds returned just 2.2% p.a. net of all fees.

Inevitability

In the end, the results were inevitable.

Given the contest went for 10 years, any short-term fluctuations in the market were soon ironed out, with the overall results close to what Buffett initially expected.

In mathematics, there is a rule called ‘The Law of Large Numbers’ which states that as the sample size grows the actual results start to approach the expected results.

For example, imagine flipping a coin. The first few flips could be all heads or all tails, but as you flip the coin more and more, the percentage of flips that are heads, will inevitably approach 50%.

The same thing happened in this contest. With the performance of the hedge fund weighed down annually by fees that were 2% higher than the index fund fees, it was inevitable that over time the index funds would do better.

Buffett explained it this way, ‘If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group have the lower costs will win’.

But the advantages of index funds in this contest didn’t stop there. While index funds simply follow the market, hedge funds have the human element, where the manager may hold biases that impact performance.

Hedge funds also tend to overtrade, which can lead to mistakes, and increase costs and taxes.

The Takeaways

After the contest was complete, Ted Seides conceded that Buffett ‘is correct that hedge-fund fees are high, and his reasoning is convincing. Fees matter in investing, no doubt about it’.

There is of course, still a huge place for active management in investing. Buffett himself is an active manager, and over the long-term has significantly outperformed the S&P 500.

The key point is that excessive fees (such as ‘2 and 20’) on any type of fund, will likely lead to underperformance over the long-term.

If one were to choose an active fund, look for a fund with low fees and a great long-term performance.