Ten years ago, Warren Buffett challenged any investor to select a fund of hedge funds that would beat the Standard & Poor’s 500 index over the next decade. The billionaire superinvestor’s aim was to prove anew that money invested passively in an index fund can beat actively managed money, after factoring in all the management fees.
The guy who took him up on the bet conceded defeat this spring. That’s a powerful — and free — lesson for individual investors and a reminder that not all the perks go to those who can afford to invest in a hedge fund.
Buffett wagered with investment manager Ted Seides, who selected a fund of hedge funds. Until year-end 2016, Seides’ fund earned an estimated 22% after management fees, compared with 85% for the S&P 500 index. For Seides, management fees ate up an estimated 60% of the gross return, suggesting that he was able to earn about 55% before fees were extracted.
Not only did the index beat the fund of hedge funds on an after-fee basis, it also thrashed it on a pre-fee basis. And fees mounted; the bet stipulated that Seides had to select a fund of hedge funds, meaning two layers of management fees. All these fees turned Seides’ decent pre-fee performance into lackluster returns.
Recently, Buffett indicated that he would be interested in repeating the bet. One investment manager leaped at the prospect, but the 87-year-old Buffett recanted shortly thereafter, citing his age when the bet would expire in 10 years. Still, the CEO of Berkshire Hathaway noted, “There’s no doubt in my mind, however, that the S&P 500 will do better than the great majority of professional managers achieve for their clients after fees,” according to a CNBC report.
Three big takeaways for individual investors
One of Buffett’s goals with his bet was to teach individual investors a few things about the stock market and how to make money. The so-called “Oracle of Omaha” has long been a font of wisdom, and here are three things that investors should take away from Buffett’s bet.
1. You don’t have to be rich to earn good returns
Everyone who is able to invest has the ability to invest in a low-cost index fund. The expense ratios on exchange-traded funds and mutual funds that track the S&P 500 index are low, and the fees have become even cheaper in recent years, often below 0.1% per year. They compare well with hedge funds — what Buffett calls the “two and 20 crowd” — which typically take 2% of your invested assets every year regardless of how the fund performs and 20% of the profits if it does well. In other words, hedge funds offer pricey advice, but they usually underperform an index fund that individuals could find for cheap.
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2. Passive investing can work magic
Part of the secret of Buffett’s bet is that he’s effectively a passive investor in the index fund, buying at the start of the bet and then holding through the 10 years. He’s not actively trading — which has been shown to severely hurt returns — and that gives him an advantage over those who are trading in and out of the market every day, trying to time their purchases.
Research shows that passive investing beats 83% to 95% of active managers in any given year. That’s a huge win for individual investors who can simply and easily beat professionals using funds.
3. continue investing in bad times
Buffett started his bet near a record high point in the market in 2007, right before the economy crumbled and the financial crisis hit. Still, the S&P 500 index handily beat the fund of hedge funds. Now, consider if Buffett had been buying stock as the market fell and adding to his position when stocks were cheap. He would have crushed the professionals merely by adding money at regular intervals.
That strategy wasn’t allowed under the terms of the bet, but that doesn’t prevent individual investors from using it. That lets you take advantage of the power of dollar-cost averaging, buying into the market at regular intervals and using a market downturn as an opportunity to buy stock more cheaply.
Like Buffett’s simple plan for individual investors? It’s easy to get started investing in passive funds like the ones Buffett used and learn how to outsmart high-priced investment managers at a low cost.