If Warren Buffett Recommends Index Funds, Why Would Anyone Invest in Other Areas?

A little over eight years ago, Berkshire Hathaway (BRK.A -0.76%) (BRK.B -0.69%) CEO Warren Buffett bet hedge fund manager Tom Seides that an investment in a low-cost S&P 500 index fund would outperform a basket of hedge funds chosen by Seides over a 10-year period. So far, Buffett's index fund has more than tripled the performance of Seides' hedge funds.

This bet, and the performance of the index fund in particular, begs the question: Should investors even bother with other investments if an index fund will generally outperform?

In this segment of The Motley Fool's Industry Focus podcast, special guest host Emily Flippen puts that question to podcast regulars Gaby Lapera and Jay Jenkins. Are index funds the best option for investors? If so, why? To find out these answers and more, click play below. 

A transcript follows the video.

This podcast was recorded on Jun. 20, 2016. 

Emily Flippen: During my internship, I've heard about a bet that Warren Buffett apparently made with a hedge fund manager. Supposedly, he bet the manager that a low-cost index fund would out perform any five hedge funds he picked out over a 10-year period. My fellow intern told me that Buffett is currently winning this bet. If this is true, why does anyone choose to invest their money in other areas? Should all of my money be in index funds?

Jay Jenkins: Let's give some background first, because that final question is the million-dollar question.

Gaby Lapera: Or the hundred-dollar question, if that's all you have.

Jenkins: Yeah, at this point. A million dollars soon enough. The hedge fund guy is named Ted Seides. The bet was, Buffett puts a bond that at the time was worth something like $350,000, but at maturity, would be worth $1 million, and Buffett put the value of that into an S&P 500 index fund. Mr. Seides would take the equivalent bond and put it into five hedge funds of his choosing. And then it would play out over a 10-year period. Whoever wins, the million dollars of that bond goes to charity of their choosing.

Inherently, I think, in the bet, Buffett had an advantage going into it. The advantage is, because Ted Seides put the money in five different hedge funds, he kind of diversified. What's that's going to do is lower the risk of putting the money into that niche of the market, into that hedge fund area, but it also eliminates his ability to put a lot of his money into one winning bet. If there's one all-star hedge fund manager who consistently puts out top returns over and over, year after year, in interest of the bet, he'd probably be better off putting it in that guy's fund. But he didn't, he diversified. With five funds, it regresses to the mean, and most likely -- and the bet has shown -- he's gotten average hedge fund performance, which is really not all that impressive over the last 5-10 years since the financial crisis. So, he diversified, but he also limited his ability to truly out-perform. 

When hedge funds make the news, it's because they have these ridiculous returns. John Paulson makes $1 billion in a year, or George Soros breaks the Bank of England like you did back in the '90s. So, you have the averaging effect, and that's made worse because hedge funds charge such large fees. 2-and-20 is the common fee structure. That means you put $1 million into a hedge fund, they're going to take 2% of your money every year just for having access to the fund, just for coming out, and then 20% of any profits, the hedge fund keeps that as well. So, because of that fee-heavy structure, even if the hedge fund manager does outperform the S&P, the S&P has an advantage because it doesn't have to do all that great. It can just almost keep up. Then, after fees, the S&P 500 may end up having a better year over all.

So, that combination of the fee-heavy structure with, essentially, the five hedge funds, that makes him an average performer through that diversification. I think Buffett had an advantage straightaway.

Lapera: Not just that, but -- I'm sure this guy picked some very reliable hedge funds -- but there's always a chance that a hedge fund we'll just go out of business, and an index fund is never going to go out of business unless there is complete economic collapse.

Jenkins: That's true. They can do anything they want, at the end of the day. They can invest in virtually anything, any amount, at any concentration. There's really no control, if these guys are free to do whatever they want. So there is that risk.

Now, should everyone just invest in low-cost exchange-traded funds, whether it be a bond fund, or an S&P 500 fund? A lot of people say that for retirement planning, that's a smart strategy -- diversify yourself through time. As you get older, you're going to want more bonds that are going to be safer to the rising and falling of the economic cycle, and when you're younger, put it in maybe a smaller-cap Russell 2000-type ETF and go that way.

The biggest advantage of that, to me, is twofold. One, you have the tax advantage of a retirement account, so you're not paying taxes on your gains until you're 60 or 70 years old. Two, these ETFs are so cheap. A Vanguard fund might charge 15 or 20 basis points to manage your money for you, while a mutual fund, or certainly a hedge fund or private equity or one of these more esoteric ways of investing, they're going to charge 2%, maybe 4%, they're going to take 20% of profits, if not more.

Lapera: Someone actually asked me this the other day, and I hadn't realized that everyone didn't know -- when Jay says 15 basis points, that's going to be 0.15%.

Jenkins: That's right, one basis point is 1/100. So, it's virtually free. When you take into account the gains, 15 basis points is nothing. It's less than pennies. So, from a value perspective, it's a great advantage. And over a 30- to 50-year period of time investing, from your time now as an intern to your ultimate retirement, saving all that money on fees adds up tremendously. It can work out to millions of dollars in certain scenarios. That's the biggest advantage. 

Other people who say that an actively managed fund can outperform over time, and there's certainly examples of very smart investors who have consistently done that. Warren Buffett is an example. There are others. It is possible, it's just very, very difficult.

Lapera: And kind of unlikely. Some facts to put out there, the Vanguard S&P 500 ETF, which goes by the ticker symbol VOO, their expense ratio as of April 27, 2016, is 0.05%, which is nothing in comparison to ... on average, I think, a mutual fund charges 1.33%. So, there are some really low-cost alternatives out there. Also, as of February, 2016, the Vanguard 500 Index Fund Admiral shares, which is what Warren Buffett put his money into for the bet, is up 65.7%, and the hedge fund managers are at 21.9% average gain. So...booyah, I guess.

Jenkins: And they have two more years to go before the bet's over?

Lapera: Two more, we're eight years in.

Flippen: Looking good for Buffett.