Back in December 2007, Warren Buffett made a ten-year US$1 million prize bet (background reading: Warren Buffett is set to win this US$500,000 wager) with asset manager Protégé Partners.
Essentially, Warren Buffett wanted to prove a point: that his pick – 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.
“Addressing this question is of enormous importance. American investors pay staggering sums annually to advisors, often incurring several layers of consequential costs,” Mr Buffett, the legendary investor who is chairman of Berkshire Hathaway, said in his FY2017 letter to shareholders.
“In the aggregate, do these investors get their money’s worth? Indeed, again in the aggregate, do investors get anything for their outlays?
“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.”
In Berkshire Hathaway’s 2005 annual report, Mr Buffett had said “that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still”.
Recalling his argument, he said in his FY2016 letter to Berkshire Hathaway shareholders: “I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund. ”
Warren Buffett named a low-cost Vanguard S&P fund as his contender.
“What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds,” Mr Buffett said in the FY2016 letter.
“For Protégé Partners’ side of our ten-year bet, Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. ”
Mr Buffett’s bottom line: 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.
In the FY2017 letter, Warren Buffett said: “The five funds-of-funds got off to a fast start, each beating the index fund in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund.”
And why did the charity, Girls Inc of Omaha, received US$2.2 million instead of US$1 million?
“Originally, Protégé and I each funded our portion of the ultimate $1 million prize by purchasing $500,000 face amount of zero-coupon U.S. Treasury bonds (sometimes called “strips”). These bonds cost each of us $318,250 – a bit less than 64¢ on the dollar – with the $500,000 payable in ten years…
“After our purchase, however, some very strange things took place in the bond market. By November 2012, our bonds – now with about five years to go before they matured – were selling for 95.7% of their face value. At that price, their annual yield to maturity was less than 1%. Or, to be precise, .88%.
“Given that pathetic return, our bonds had become a dumb – a really dumb – investment compared to American equities. Over time, the S&P 500 – which mirrors a huge cross-section of American business, appropriately weighted by market value – has earned far more than 10% annually on shareholders’ equity (net worth).
“In November 2012, as we were considering all this, the cash return from dividends on the S&P 500 was 21⁄2% annually, about triple the yield on our U.S. Treasury bond. These dividend payments were almost certain to grow. Beyond that, huge sums were being retained by the companies comprising the 500. These businesses would use their retained earnings to expand their operations and, frequently, to repurchase their shares as well.
“Either course would, over time, substantially increase earnings-per-share. And – as has been the case since 1776 – whatever its problems of the minute, the American economy was going to move forward.
“Presented late in 2012 with the extraordinary valuation mismatch between bonds and equities, Protégé and I agreed to sell the bonds we had bought five years earlier and use the proceeds to buy 11,200 Berkshire “B” shares. The result: Girls Inc. of Omaha found itself receiving $2,222,279 last month rather than the $1 million it had originally hoped for.”