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Have you heard about the $1 million dollar bet Warren Buffett made with a famous hedge fund manager? The bet was: Could a group of hedge funds, professionally selected, beat an index fund over a 10-year period?
The hedge fund manager, Ted Seides, accepted Buffett’s challenge and picked a group of five hedge funds that he expected would collectively outperform an index fund chosen by Buffett. The winner would get $1 million donated to a charity of his choice. Each man put $320,000 in bonds (for a total of $640,000) that was supposed to mature to $1 million by 2018. (By the way, if you’re wondering what the rate of return is that will grow your money from $640,000 to $1 Million in 10 years, it’s 4.51%.)
Buffett picked the low-cost Vanguard 500 Index Fund Admiral Shares (VFIAX) which is based on the S&P 500 index, but the names of the hedge funds were never publicly released to protect their reputations.
And, so far, Warren Buffett is winning big. His index fund was up nearly 66% from the time the bet began in 2008 until the end of 2015, a return of about three times that of the funds chosen by Seides, despite the fact that the index underperformed the hedge funds last year.
Thanks to an article about this on Yahoo Finance by Lawrence Lewitinn, there are a number of quotes by Wall Street legend, John Bogle, founder of the Vanguard Group and pioneer of index funds. Bogle was interviewed about this and said Buffett “is a believer” that hedge funds can’t beat the market over time. Bogle said of Buffett, “He’s been talking about indexing and the S&P 500 since before I ever met him.” In fact, Buffett believes in index funds so much that he has set up a trust for his wife’s estate and has directed that 90% of it be invested in a low-cost S&P 500 index fund.
Referring to this bet, Bogle said Ted Seides made a big mistake when choosing his hedge fund managers. And that mistake is one of the things working in Buffett’s favor in the bet. You see, Seides chose a basket of five funds. Seides chose to hedge his bet a little by attempting a little bit of diversification, to cut down his risk. Bogle thinks he might have actually done better if he had put all his money into one or two high-flyers.
A single hedge fund can do just about anything. When you get five of them together, they’re going to more or less average each other out. And hedge funds have not done very well for the past seven or eight years. There are a lot of very smart, very aggressive people in the Hedge Fund business because it is extremely lucrative if you’re successful.
And since there is such a high level of competition, it’s hard coming out on top.
Bogle also warns those who pick stocks. He talks of the explosive growth of stocks such as Facebook (FB), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG, GOOGL) – the so-called “FANG” stocks – and cautions investors by saying:
“More power to you if you picked them at the very beginning, but I don’t know anybody who did. To look at them today, as if they’re going to repeat their fantastic early record, is just extremely unwise. The trick is picking the next Google or the next Apple, all of these names that are relatively new to investing, but that is just a really hard job.
He warns investors against looking back and seeing what funds or stocks did in the past because, as we all know, past performance is no guarantee of future success, and there’s a lot of what’s called reversion to the mean. The good funds tend to go down to the average, and the bad funds and stocks tend to go up to average.
So here are the main takeaways. You’re almost always better off playing it safe and investing the bulk of your assets in index funds, just as Buffett wants 90% of his wife’s estate invested in index funds, which provide diversification with full exposure to U.S. equities. Invest the other 10% in a variety of other assets such as dividend-focused index funds, etc. You’ll also pay the lowest amount in fees if you go the index fund route because actively managed funds typically ask for higher fees—although, I will say, those fees are coming down big.
So avoid trying to get rich by betting big on a few winners; instead, keep it simple and go with the path of least expense and the highest probability of reasonable returns.
And if you don’t know what you are doing, be smart and find a good investment advisor to help you.