Berkshire Hathaway is the single largest conglomerate in the world, it’s also the fourth largest public company overall behind three Chinese banks: ICBC, China Construction Bank and the Agricultural Bank of China. This success is often put down to the visionary leadership of its Chairman, President and CEO, Warren Buffet.

When Buffet purchased Berkshire Hathaway In 1964 it was a failing textile manufacturing company. Since taking the helm, the company’s stock has grown by a staggering 1,826,163%. That’s not a typo. It’s Class A shares are worth over $225k, making them the highest-priced shares on the NSYE. To say that Buffet knows a thing or two about investment analysis is an understatement.

Every year from 1977 Warren Buffet has written a letter addressed to the shareholders of his company. Apart from discussing the results, activities and vision for Berkshire Hathaway, Buffet also uses the platform to share some of his experience and advice on investing. This discussion is the main reason most people read these letters and to be honest, they are a phenomenal read. If you’re serious about investing, it makes every sense in the world to read the reflections of one of most successful investors in history.

All letters published from 1977 to date can be found here for free. While still interesting, you can skip the performance and analysis of Berkshire and go straight to Buffets’ more critical analysis of investing in general.

If this format isn’t comfortable to read, I would thoroughly recommend the following book which compiles 50 years of Buffet’s letters in one place. The letters are 100% word-for-word reprints and are put together in a more reader-friendly arrangement.

 

Buffet’s Million Dollar Bet: Index Funds Vs. Managed Funds

It’s Buffet’s latest letter in the 2016 Berkshire Hathaway Annual Report that is the focus of this article, particularly the comments that makes around his views around hedge funds.

There’s a site called Long Bets which was established in 2003 as a new way to stimulate philanthropy and discussion among philanthropists. Basically you can make any long-term prediction with almost anyone you like and be held accountable by the administrators of the website. The proceeds are typically given to a charity of the winning parties’ choice. There are several examples of many famous investors having made a number of interesting bets:

In 2002, entrepreneur Mitch Kapor asserted that “By 2029 no computer – or ‘machine intelligence’ – will have passed the Turing Test,” which deals with whether a computer can successfully impersonate a human being. Inventor Ray Kurzweil took the opposing view. Each backed up his opinion with $10,000

Craig Mundie of Microsoft asserted that pilotless planes would routinely fly passengers by 2030, while Eric Schmidt of Google argued otherwise. The stakes were $1,000 each.

Buffets’ bet was something different, in 2007 he placed a million dollar bet with Ted Seides of Protégé Partners. Buffet asserted that:

“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”

This is Buffet’s argument: Investors on average and over time, will do better with a low-cost index fund that with an actively managed hedge fund.

The rules of the bet were agreed:

Ted would hand pick five funds-of-funds (i.e. hedge funds that invest in other hedge funds) for which he would average the returns of over the 2007 to 2017 time period.

Buffet picked the famed low-fee Vanguard S&P 500 index fund.

The rationale behind Buffet’s bet is quite simple, it’s based on one key idea. First he divides investors into one of two types:

 

Passive Investors:
These investors are happy with average returns. They invest in heavily diversified funds, they limit their risk and thus their return. These investors don’t try to “beat” the market, they simply take it as it comes- they don’t make wild and frequent adjustments to their portfolio. These funds involve little manual intervention and thus, incur only minimal fees.

 

Active Investors:
Active investors are constantly trying to “beat the market”. For these investors an average return is not enough, they try to squeeze every penny out of the market. In order to do this, the make deposits into hedge funds where the investment monitored with intense scrutiny and micro-managed incessantly in order to maximise returns. Hedge funds hire a lot of very smart people in order to achieve this. These smart people of course require large fees, fees which are imposed in the investors of hedge funds. In order for an active investor to beat the market, not only must they make above average returns- but they must overcome the fees that are imposed by the hedge funds they invest in.

“Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation…  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.”

 

Buffets Argument: The Law of Averages

This is the argument that Buffet puts forward: the passive investors invest in funds that mimic the average movement of the market, they do average by definition.

If passive investors do average, what does that mean of active investors? Buffest suggests that these “active investors” must also, as a whole, be doing average.

There is one key difference between active and passive investors however and that is fees. Hedge fund managers work tirelessly and they certainly don’t work for free. When the hedge fund performs well, the fund managers pay their selves a performance fee. This fee takes a significant chunk out of any return that an investor can expect to make.

Think these fees are inconsequential? Buffet estimates that 60% of all returns you can expect to make are diverted to hedge fund managers. Hedge fund managers not only charge a commission on any returns they make, they often place a fixed management fee on top which is charged irrespective of whether or not the fund makes a return

If both passive and active investors make average returns. But the cost of investing for passive investors is lower; passive investors should theoretically make a higher return in the long run.

This is the argument that Buffet put forward when placing his one million dollar bet. Theories are great, but the bet ends this year so how did it play out? The results are presented below and show compellingly that Buffet was on to something.

Buffet’s S&P index fund vs. Ted’s five hedge funds show that the index beat the managed funds in seven of the nine years of the bet’s history. When looking at the overall compounded return to date (adjusted for fees) we can see that the index fund significantly outperformed all of the hedge funds between 2008 and 2016. It’s a very safe bet to say that Buffet will be the victor when this bet matures later in 2017.

Does This Mean You Can’t Hope to do Better Than Average?

In his letter, Buffet does point to outliers. He claims:

“There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat.”

Ten or so professionals. If one of the most revered investors in history claims to only know ten or so people who care capable of outperforming the index in the long run, what hope does the layman have? Buffet simply recommends investing in a simple S&P 500 index fund. He was willing to put his money where his mouth was and to be frank, it is going to pay off to the tune of one million dollars this year.

Of course, buffet is not claiming that it’s impossible to beat the market. On the contrary, Buffet makes the following statement:

“There are no doubt many hundreds of people – perhaps thousands – whom I have never met and whose abilities would equal those of the people I’ve identified. The job, after all, is not impossible. The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: “In investment management, the progression is from the innovators to the imitators to the swarming incompetents.”

Following Buffet’s earlier logic on active investors necessarily performing average as a whole, we can safely conclude that about half of them must be doing above average. Of course, they must not only do better than average, they must also beat make returns over and above the fees they impose on their clients. There are undoubtedly funds out there that can do this. If you know a fund is going to significantly beat the market, of course it makes sense for you to invest in the hedge over a simple low-cost index fund. But how do you know which funds are best? Can you simply look at a hedge fund’s history in order to predict their success? Buffet doesn’t think so:

“Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him”

If the dice is rolled enough times, there will of course be statistical anomalies from time to time. This does not mean it’s anything more than roll of the dice.

Buffet concludes his point with the same advice he’s given for most of his career:

“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.”