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Eleven years ago Buffett offered a bet ($500,000 to go to charity) that no investment professional could select a set of at least five hedge funds that would over a period of ten years match the performance of the S&P500 after fees. He choose a low-cost Vanguard S&P fund as his contender.
“I explained [in 2005] 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.” (2016 Letter to Berkshire Hathaway shareholders)
Just how confident were these fund managers – surely they’d rush to take up the bet?
“I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?
What followed was the sound of silence.
Only one stepped forward, Ted Seides, 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.
He picked the five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. They invested their money in more than 100 hedge funds.
The problem with fund-of-funds is that the hedge funds first charge their fees and then the fund-of-funds manager takes are large cut on top.”
The shocking results over nine years
Three of the funds chosen barely gave back the original amount, compared with an 85.4% return on the S&P500. The average annual return on the five funds was 2.2% whereas the S&P500 gave a fairly typical annual return of 7.1%.
| Year | Fund of funds A | Fund of funds B | Fund of funds C | Fund of funds D | Fund of funds E | S&P 500 index |
| 2008 | -16.5% | -22.3% | -21.3% | -29.3% | -30.1% | -37% |
| 2009 | 11.3% | 14.5% | 21.4% | 16.5% | 16.8% | 26.6% |
| 2010 | 5.9% | 6.8% | 13.3% | 4.9% | 11.9% | 15.1% |
| 2011 | -6.3% | -1.3% | 5.9% | -6.3% | -2.8% | 2.1% |
| 2012 | 3.4% | 9.6% | 5.7% | 6.2% | 9.1% | 16.0% |
| 2013 | 10.5% | 15.2% | 8.8% | 14.2% | 14.4% | 32.3% |
| 2014 | 4.7% | 4.0% | 18.9% | 0.7% | -2.1% | 13.6% |
| 2015 | 1.6% | 2.5% | 5.4% | 1.4% | -5.0% | 1.4% |
| 2016 | -2.9% | 1.7% | -1.4% | 2.5% | 4.4% | 11.9% |
| Gain to Date | 8.7% | 28.3% | 62.8% | 2.9% | 7.5% | 85.4% |
“Girls Inc. of Omaha, the charitable beneficiary I designated to get any bet winnings I earned, will be the organization eagerly opening the mail next January.” (2016 BH Letter)
Despite the high potential rewards for fund managers who out-perform, their results were “really dismal”. The huge fees, often 2% fixed and 20% of profits meant that the managers gained tremendous over those years, but these were “totally unwarranted” judging by what clients received. On top of those fees the fund-of-funds managers usually get 1% of assets.
“I estimate that over the nine-year period roughly 60% – gulp! – of all gains achieved by the five funds-of-funds were diverted to the two levels of managers. That was their misbegotten reward for accomplishing something far short of what their many hundreds of limited partners could have effortlessly – and with virtually no cost – achieved on their own.”
Active investors in aggregate give an about average performance. But, in contrast to passive fund investors, incur high costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.
How active managers should be paid
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