The big lesson from Warren Buffett’s bet

Since this is a week for Buffett and Berkshire, now seemed like a good time to revisit the famous bet that Warren made with Ted Seides, CFA, and President / Co-CIO of Protégé Partners on who would win over 10 years – the S&P or a selection of 5 fund of funds chose by Protégé. The S&P has crushed them the past 7 years.

Ted has now put out an article discussing the bet and where they stand to date.

“Hedge fund underperformance over the last seven years raised the question of whether hedge funds are bent or broken. Standing seven years into a 10-year wager with Warren Buffett, we sure look wrong.”

Well he certainly didn’t try to deny it. So what went wrong?

“Just over half (24.4% ÷ 43.9% = 55.6%) of the underperformance by hedge funds can be attributed to fees.”

Now we can discuss what happened with the other half. There are plenty of good reasons. Cash drag. Huge outperformance by US markets, so anyone allocating internationally (developed or emerging) would have underperformed, etc… But in reality it doesn’t matter. Because HALF of the underperformance is fees. Had we used a better global benchmark, the funds would still have underperformed, because of FEES.

The lesson is simple:

PLEASE STOP PAYING HIGH FEES. IT MAKES NO SENSE.

If you can, manage it yourself. If you can’t, you can find some incredibly simple ETF’s that will take care of it for you, or you can buy 5-6 that do the same thing. Rebalance occassionally. Done. If you really  need an adviser, get one. Don’t pay 2 & 20 or overpay for mutual fund (who are probably closet indexers anyway).

Buffett’s comments have turned out more true that most would have believed. Below is the original quote from when the bet was made:

“Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.

A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.

For more head over to PragCap or read Ted’s article on the CFA Tumblr.