Broker Check

Warren’s Bet

February 26, 2018

The release of Berkshire Hathaway’s annual report is one of the most anticipated events for investment nerds everywhere.

The first fifteen or so pages, titled “Chairman’s Letter,” are always carefully scrutinized and widely quoted. This section is personally penned by none other than Warren Buffett, the Oracle of Omaha, an all-time investing legend.

The reason the letter receives so much attention is certainly due in part to Warren’s incredibly successful career. Equally important is the fact that he is an extremely gifted communicator with the rare ability to distill complicated concepts into simple words using his “folksy” wisdom and writing style.

(Click HERE to read the letter or the annual report)

The Bet

In this year’s letter, Warren reported the final results of his 10-year bet against the hedge fund industry.

The essence of the bet, initiated in 2007 on the eve of the Great Financial Crisis was that:

“a virtually cost-free investment in an unmanaged S&P 500 index fund – would, over time, deliver better results than those achieved by most investment professionals, however well-regarded and incentivized those “helpers” may be.”

With Warren taking the side of the unmanaged S&P 500 index, on the other side of the bet were the best and the brightest practitioners of the investing profession:

“Protégé Partners, my counterparty to the bet, picked five “funds-of-funds’ that it expected to overperform the S&P 500. That was not a small sample. Those five funds-of-funds in turn owned interests in more than 200 hedge funds.

Essentially, Protégé, an advisory firm that knew its way around Wall Street, selected five investment experts who, in turn, employed several hundred other investment experts, each managing his or her own hedge fund. This assemblage was an elite crew, loaded with brains, adrenaline and confidence.”


Warren’s side of the bet was off to a poor start: 2008 was one of the worst years in stock market history: the S&P 500 index lost 37%, trailing all five competing funds.

In the subsequent nine years, however, the S&P 500 crushed the competition. Here are the official results:

Average annual returns:

  • Five funds: 2.5%
  • S&P 500 index: 8.5%

Total returns:

  • Five funds: 28.4%
  • S&P 500 index: 126.1%

To translate into dollars, had you invested $10,000 into the five funds at the start of the bet, at the end of 2017 you would have ended up with about $12,840 in your account.

Had you invested into an S&P 500 index fund, your account would have grown to $22,610, an astounding performance difference.

But Why?

How can a dumb index fund outperform Wall Street’s “elite of the elite” fund managers by such an astonishing margin?

One word: Fees.

As always, Warren explains it best (emphasis ours):

“Every actor on Protégé’s side was highly incentivized: Both the fund-of-funds managers and the hedge-fund managers they selected significantly shared in gains, even those achieved simply because the market generally moves upwards…

“…Those performance incentives, it should be emphasized, were frosting on a huge and tasty cake: Even if the funds lost money for their investors during the decade, their managers could grow very rich. That would occur because fixed fees averaging a staggering 2.5% of assets or so were paid every year by the fund-of-funds’ investors, with part of these fees going to the managers at the five funds-of-funds and the balance going to the 200-plus managers of the underlying hedge funds.”

“…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 on investors.”

This fee arrangement resulted in a greatly lopsided division of investment gains and was the root cause of the funds’ long-term underperformance.

In Warren’s estimation, these highly incentivized helpers kept “roughly 60% of all gains” achieved by the hedge funds.

It return for the privilege of calling themselves hedge fund investors, clients were socked with the double whammy of exorbitant fees and severe long-term under-performance.

Why Should You Care?

You may be thinking: “Who cares? After all, I am not invested in hedge funds and never will be.”

Unfortunately, the same principle is very much at work in the so-called “retail investing” world, where ordinary hard working people save money in retirement and brokerage accounts.

Although the fee situation in this arena has been slowly improving, essentially every investment portfolio we have reviewed for prospective clients falls in the “high-fee/lousy-performance” category.

The vast majority of portfolios we review pay between 1.50% and 2% in total annual fees. Sadly, we have also seen a few portfolios over the last three months where annual fees are closer to 3%.

To translate a 3% annual fee into plain English:

Every ten years, fees will consume roughly ONE THIRD of your investment portfolio

Let that sink in for a second.

Adding insult to injury, when we review this information with prospective clients, they are without exception caught unawares. Fees are essentially never clearly disclosed on brokerage statements.

The Bottom Line

There is clearly more to investing than just finding the cheapest available funds.

Also, investing an entire portfolio in an S&P 500 index fund like Warren did in his bet is not suitable for most investors given their unique circumstances and objectives.

However, as practitioners of evidence-based investing, we must acknowledge that fees are the most critical driver of a portfolio’s future performance and take every effort to carefully manage and minimize their impact.

As the Oracle of Omaha put it:

“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”