Buffett’s $1 Million Challenge
For nearly 60 years investors have hung off every word Warren Buffett has said, much in the same way sportspeople follow a meteorologist. He has had the most robust consistent investment performance of our time and those who follow him and know him as the sage of Omaha.
So in 2008 Warren Buffett, one of the richest men on the planet and Chairman of Berkshire Hathaway, issued a challenge to the hedge fund industry and people paid attention.
He contended that a hedge fund manager could not outperform an S&P index fund¹ over a ten year period. He believed that the high management fees and costs, could not justify the performance and that investors were better off investing in low-cost index funds. He then put a million dollars on the table for anyone who would take that bet.
Warren Buffett won his one-million-dollar challenge, after American hedge fund manager Ted Seides at Protégé Partners took it up. Ted Seides conceded defeat in 2017 before the time on the bet had expired.
The results?
Over the ten years, Warren’s index fund (OEX) returned 125.8%, while the undisclosed portfolio of Protégé Partners employed multi-manager investments (also know as fund of fund investments), returned 36%. The winnings were donated to the winners choice of charity, and for Warren, the charity was Girls Inc.
Protégé Partners didn’t lose entirely from the bet either. A building the donations income supports was named in their honour! Protégé House!
Were the results really that definitive?
That looks clear enough. Why would you consider managed funds again when index funds clearly outperform? We have a stark performance comparison, over the same period and most in the finance industry know about it. It unequivocally proves the point that index funds are better than managed funds. Case Closed.
The simple answer is no. As much as I would like to support the biases introduced so far in this article, as with most things, there is a lot more to unpack.
The sum that was eventually donated to Girls Inc. was $2.2 million, much more than the initially agreed $1 million
How did they get $2.2 million?
At the outset, both participants invested $300,000 into US Treasury bonds. That should have covered the million-dollar bet by the maturity date in 10-years. But in 2012 both parties concluded that the investment was rubbish. They decided to withdraw the funds and invest in Warrens own holding company, Berkshire Hathaway.
That investment grew to $2.2 million over the remaining 7-years of the bet.
Better than the initial Treasure bonds, better then Protégé Partners portfolio, and much better than the index fund that scored line honours!
What’s Berkshire Hathaway?
Berkshire Hathaway is a listed holding company. It researches, buys and holds companies they think are under-appreciated by the market, and they believe will outperform over a given period… exactly like a managed fund.
Berkshire Hathaway has had compound growth rates of 20.3% since the 1960s. The stock price has grown from $7.60 a share in 1962 (when Warren began buying it), to more than $300,000 today. When Warren took over in 1965, you could purchase shares in his company on the US stock exchange for around $14.00.
And you can read about that here.
A couple of things to note on the conclusion of the wager:
- Warren and his firm have never been index investors.
- When he dies, he wants his assets (Any not earmarked for the Giving Pledge) to be invested in low-cost index funds and bonds for his wife*.
- After winning the bet, his company didn’t pivot, sell their holdings and invest in index funds.
- They believe that excellent company research, analysis and robust methodology can still outperform the market.
Is there a difference between a hedge fund and a mutual fund?
Pooled investments² are definitely not all the same. Both are also active investments³ that research and select which investments to buy. However, a hedge fund will generally work to profit from directional positions (known as being long or short) in complex instruments called derivatives4. The fees for managing these portfolios are significant. Generally 2+% PLUS a 20% bonus any time the fund manager beats the underlying index.
These complex financial instruments and can be extremely volatile. For this reason, they are often only offered privately to accredited sophisticated investors.
A mutual fund may occasionally employ hedges, but the idea is not to profit from the position, but rather protect the portfolio’s investments. For example, an Australian portfolio manager investor investing in American companies may hedge the currency risk to protect the portfolio if the Australian dollar increases.
Final note
The bet started almost at a perfect time for passive investments. In 2009, the world was still contesting with the remnants of the GFC. It wasn’t difficult to make money between 2009 and 2017… unless you were playing both sides of the market.
In the previous cycle from 2002 to 2007, the results were somewhat different. Over that period, Protégé Partners portfolio returned 95% net of fees versus 64% for the S&P500. So clearly market conditions matter.
What can you take away from this?
Investing is notoriously complex. With years of experience and a top education, the best of the best are not impervious to mistakes. Trying to navigate this space without advice, especially when it is not your forte, adds significant risk to achieving your goals, to your lifestyle and to the legacy you intend to leave your family.
I would argue that the most important thing you need to understand when investing is the downside risks in their entirety. What happens to you financially if…?
* Keep in mind that a 1% return on $88.5 Billion is still $885 million
- An index fund is considered a passive investment. It has no management team making discretionary investment decisions on where to invest. It tracks the underlying index (for example ASX200, S&P500, THE FTSE or other market gauge) in the same way a train follows its train tracks.
- A pooled fund is an investment that includes other peoples money. The money is aggregated together to get better diversification and pricing than you ordinarily would have if you were investing on your own. You buy units in a pooled investment, and the manager invests that money on your behalf.
- An active manager or investment will employ teams of researchers and analysts to review everything about a company they plan to invest before they buy into it. This can include examining balance sheets, competitors and governing laws, to touring the business facilities, talking to company directors, review and test the product… anything that you can think of that can have a material impact on the company and your investment.
- A Derivative is a financial asset that relies on a secondary asset’s performance to determine its value. The underlying asset can be a company listed on the stock exchange, interest rates, foreign currency, an index etc. The derivative itself can also vary. They can be an option, a futures contract, forwards, warrants etc.
