By now, you’ve probably heard that the Oracle of Omaha won the so-called million-dollar bet against Ted Seides, a co-manager of Protégé Partners.
Here’s what happened: In 2005, Buffett said investment management costs far too much money. And hedge funds, he continued, were the worst of the lot. He also said he would put his money where his mouth is.
In his 2016 letter to Berkshire Hathaway shareholders he wrote, “I publicly offered to wager $500,000 [in 2005] that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would, over an extended period, match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender.”
That’s no burger-stuffing contest. That’s why I was surprised when Mr. Seides accepted the challenge. He picked five funds-of-hedge funds that would battle Vanguard’s S&P 500 Index over the 10-year period ending December 31, 2017. Each hedge fund contained a series of hedge funds within it. Each of those funds likely had a great track record. But past results aren’t winning lottery tickets.
In March 2015, SPIVA reported that 568 U.S. stock market mutual funds were among the top 25 percent of performers. By March 2017, SPIVA determined how many of those funds remained among the top quartile. Just 1.94 percent maintained their winning ways.
Hedge funds cost a lot more than most actively managed funds. That’s why the majority perform poorly. They typically charge 2 percent per year plus 20 percent of any profits earned. If that’s not bad enough, a fund of hedge funds often charges an additional 1 percent. Fees helped to sink Mr. Seides’ ship. But they weren’t the only factor.
If a typical hedge fund earns 8 percent before fees, its investors would only earn 4.8 percent. Fees would eat the difference. If a fund of hedge funds collected an additional 1 percent fee, the investors would make just 3.8 percent per year.
Hedge Fund Investors Give Up A Lot
|Pre-Fee Annual Gain||5%||8%|
|Result after 2% management fee||3%||6%|
|Deduction equal to 20% of the profits made||-0.4%||-1.2%|
|Net Gain after fees||2.6%||4.8%|
Over Buffett and Seides’ 10-year bet, Vanguard’s S&P 500 gained a compound annual return of 7.1 percent per year after fees. That includes the market’s dump in 2008. In contrast, Protégé Partners’ hedge funds averaged a compound annual return of just 2.2 percent after fees.