A famous bet made almost ten years ago between Warren Buffett and Protégé Partners, LLC, pitting five funds of hedge funds against an S&P 500 index fund, will end in December. Neither protagonist believes the outcome is still in doubt.
Under the terms of the wager, each side put up $500,000, with the proceeds to go to a charity of the winner’s choice. The wager concerned the performance over the ten year period to the end of 2017 of paper portfolios invested in (for Buffett) a Vanguard S&P 500 index fund and (for Protégé Partners) five funds of hedge funds, with exposure to more than one hundred hedge funds in all. Full details of the wager are available here.
In his 2016 letter to Berkshire Hathaway shareholders, Buffett describes the results over the first nine years as “leaving no doubt that Girls Inc. of Omaha, the charitable beneficiary I designated…, will be the organization eagerly opening the mail next January.” Ted Seides, who initiated Protégé Partners’ participation in the bet, agrees: in a May article on Bloomberg, he conceded that “with eight months remaining, for all intents and purposes, the bet is over. I lost.”
We can presumably expect plenty of comment when the result becomes official at the end of the year, but since the two principal players have announced the result already, it’s not too soon to conduct an initial post–mortem.
Buffett’s comments on the result of the bet focus on fees: fees are the reason he offered the wager in the first place, his rationale for why he expected to win, and his explanation, after the event, for the outcome of the wager. Seides’ response is that fees are not the whole story. He warns “be careful comparing apples and oranges” and points, for example, to lower returns on non–U.S. stocks as having been a headwind for the hedge fund managers. Furthermore, when markets fell, the hedge fund portfolio tended to fall less far, and when markets rose, the hedge fund portfolio tended to rise more slowly; indeed, the return patterns imply an overall effective exposure to cash of around 40–45% for the composite hedge fund portfolio.
Although we don’t know exactly what securities the hedge funds hold, we can say, based on the return patterns, that they tracked a mixture of U.S. stocks, international stocks and cash better than they tracked the U.S market alone. This is shown in the chart below which compares the (dotted) hedge fund portfolio performance with (a) the S&P 5001 and (b) a mix of 30% S&P 500, 25% MSCI All Country World Index2 and 45% cash.
Cumulative performance 2008–2016
Notably, the performance shortfall shrinks, but does not disappear, when compared to the composite: from 4.9% a year (2.2% vs. 7.1%) to 1.5% a year (2.2% vs. 3.7%). That paints a better picture for the hedge fund portfolio, but would not have changed the outcome of the bet.
A fast rabbit?
Some would argue that the composite return pattern is irrelevant: Buffett’s side of the bet was unambiguously the S&P 500 fund all along. Indeed, some readers may be wondering why Seides did not select hedge funds with an effective exposure to the market of more than 100%. After all, this was a straight horse–race, not a risk–adjusted one. A leveraged portfolio would, with hindsight, have been a smart choice.
But remember that the bet was made in 2007; market valuations were high and Seides argues that “probabilities strongly suggested the S&P 500 would generate low returns in the future.” So he seems to have been deliberate in his decision to bet not only on hedge fund manager skill, but also against the S&P 500 itself. And while that decision appeared to be a good one in 2008, valuations as we approach the end of 2017 are back at the high end of the range and the U.S. has turned out to be, relative to other markets, a fast rabbit.
Fees matter. So does timing.
I expect that there will be more written about this bet over the next few months. The main takeaway should be the obvious one: that fees matter (a lot). But there is a second takeaway, too: that timing matters (a lot). If, instead of outperforming the mixed portfolio by 3.4% a year, the S&P 500 had underperformed by the same margin, then that may well have been enough to change the outcome of the bet. And that would have led to some very different headlines.
1The S&P 500 is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.
2Source for MSCI data: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities of financial products. This blog is not approved, reviewed or produced by MSCI. The MSCI All Country World Index is a market capitalization weighted index designed to provide a broad measure of equity–market performance throughout the world.