You have to love the guts of the Oracle of Omaha. 

Last month, Warren Buffett, the CEO of Berkshire Hathaway, bet that a collection of carefully selected hedge funds will not beat the returns of the S&P 500 over the next 10 years.

Buffett made the bet against Protégé Partners LLC, a New York City money management firm that runs funds of hedge funds.  Protégé bet that the averaged returns of five funds of hedge funds will deliver higher returns than the fund Buffett selected: a low-cost Vanguard S&P 500 index fund. 

Each side bet about $320,000.  The total of $640,000 was used to buy a zero-coupon Treasury bond that will be worth $1 million by the time the bet concludes and will be donated to charity.

The real test here is a more general philosophical difference and one that I’ve written about–whether index funds are better than actively-managed mutual funds.  Buffett has long argued that the fees of hedge funds and other funds are very large, (and he’s right). 

Warren Buffett graphic 1The Bet

At the May 2006 Berkshire annual shareholders meeting, Buffett offered to bet any taker $1 million that, over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose.  Being the gamesman that he is, he repeated the offer when no one bit, arguing that, since no one had taken the bait, he had to be right.

In July 2007, however, Ted Seides, a principal of Protégé, wrote to Buffett and accepted the bet.  The two sides negotiated and settled on the present terms of the bet.

And it looks like Seides and Protégé are no slouches: From July 2002 until the end of 2007, Protégé’s main fund gained 95% (after all fees), which handily beat the Vanguard S&P 500 index fund’s 64% over the same period.

Buffett and Seides agreed that they’d disclose where the wager stood at Berkshire’s annual meeting every spring.

Hedge Fund Fees vs. Index Fund Fees

The fees involved with these funds are Buffett’s MAJOR advantage.Warren Buffett graphic 2

A fund of funds–like the ones Seides and Protégé run–normally charges a 1% annual management fee.  The hedge funds it puts that money into charge an annual management fee of their own, which, for funds of funds, is typically 1.5% (paid quarterly).

So we’re currently at fees of 2.5% of an investor’s money.  And remember . . . this is regardless of the returns earned during the year. 

Now, on top of the management fee, the hedge funds typically collect 20% of any gains they make.  That leaves 80% for investors.  The fund of funds then takes 5% (or more) of that 80% as its share of the gains.  Thus, an investor earns only 76% or so of his or her annual return, with the rest going to the “helpers” that Buffett comically refers to in his annual letters.  And don’t forget, the investor is paying his that management fee of 2.5%, too. 

By contrast, Vanguard’s S&P 500 index fund had an expense ratio in 2007 of 0.15% for ordinary shares and 0.07% for “Admiral” shares (available to large investors).  Buffet bought the Admiral shares for this bet.

This huge discrepancy in fees simply means that Protégé has to do A LOT better than the S&P in order to win the bet.

Gentlemen, start your engines.

If you like this post, please consider subscribing to my full RSS feed.  You can also subscribe by e-mail and have a copy of each new post automatically delivered to your inbox.

If you like this post, please bookmark it: These icons link to social bookmarking sites where readers can share and discover new web pages.
  • del.icio.us
  • StumbleUpon
  • Propeller
  • Digg
  • Technorati
  • Reddit