Remember back in 2011 when Mitt Romney challenged Rick Perry to a $10,000 bet (on his health care record) in a presidential primary debate? Well, if tossing around $10,000 makes you look a bit out of touch, Warren Buffett is in another stratosphere.
In 2007, the “Oracle from Omaha” bet a New York hedge fund $1 million that his simple, low-cost investing strategy would outperform the hedge fund industry over 10 years.
And he won.
He’s a Nebraska-based investor with a famously frugal lifestyle and a net worth in the billions.
He’s also well known for his accessible investing advice: Buffett believes most money-management companies can’t outperform the market by picking stocks. And even if they do, the high fees will wipe out any extra returns. That’s why he tells non-pro investors to buy passively run index funds, low-fee funds that track a market index.
In the bet, Buffett picked a Vanguard fund that tracks the S&P 500, while Protégé Partners, a firm that puts clients’ money into funds made up of hedge funds, took the other side of the bet with five of its funds.
For decades, investors with millions to invest—from the very wealthy to pension fund managers—have been dabbling in hedge funds, hoping that the high-paid talent and secretive strategies will deliver outsized returns, even during downturns. The term “hedge fund” comes from the idea of hedging against the risk of losing money, or using investment strategies that can make money in any economic environment.
Today, how hedge funds get paid is as much of what defines them as their investing strategies. Hedge funds take an automatic fee—usually 2 percent of the money under management—and a portion of any profits (typically, 20 percent). Those fees are astronomical compared to Buffett’s index fund’s .05 percent expense ratio. So the hedge fund’s performance had to be very, very good to compensate.
Big time. Although it wasn't technically supposed to end until December 31, 2017, Protégé Partners' co-founder Ted Seides has conceded. Why so early? Because as of the end of 2016, Seides' five funds had only gained 2.2 percent a year since 2008, for a total of $220,000, compared to S&P 500 gains of 7.1 percent, or a total of $854,000.
The writing was already on the wall last year, when Buffett announced the index fund was beating the hedge funds by nearly 44 percentage points. And that was over a period that included a major financial crisis, which could be expected to favor the hedge fund. Protégé did lose less in the crisis (24 vs. Buffett’s 37 percent), and it took Buffett’s investment four years to make up the ground and pull ahead. But the index fund still came out on top.
Well, Buffett’s not giving us a piece of his winnings or anything; it’s going to charity. But his bet does underscore a powerful investing lesson we can all benefit from: You might get lucky every once in a while trying to time the market, but over time, it often doesn’t even work for the pros.
What works? As Buffett himself would tell you, investing in a mix of low-cost funds with the aim of building wealth over time—and patience.
This post was updated on September 18, 2017.