The Truth Behind Buffett's Big Bet

Ten years. Two contenders. One winner of a $1 million prize.

On one side, legendary investor Warren Buffett; on the other, fund of hedge funds operator Protege Partners. The battle? Whose net returns will be higher over the next decade: five of the world's most successful hedge funds ... or the passive Vanguard 500 Index Fund?

If it's not obvious by now ...
Buffett believes the index fund will win. It might seem shocking that he'd put so little confidence in such bright investors, but a judgment of investing prowess isn't the reason behind Buffett's bearish bet.

Instead, as he explained in a recent Fortune article, the hedge fund managers' efforts "are self-neutralizing, and their IQ will not overcome the costs they impose on investors." [Emphasis mine.]

Buffett's not insulting the investing acumen of hedge fund managers. But he is making a pretty bold statement about the fees they're charging, and how quickly they destroy investors' wealth.

It all comes down to the price you pay
Every year, the typical hedge fund collects 2% of the amount invested, as well as 20% of any profits made. It's not difficult for any student of mathematics to understand that, over time, this seemingly small amount can become quite significant.

And although you might not invest in hedge funds, odds are you have a mutual fund or two -- maybe even more -- in your portfolio. Those funds might charge similar fees that could prevent you from cashing in on gains made with your money.

Compare these two seemingly identical index funds:

Fund Name

Vanguard 500 Index

MainStay S&P 500 Index A

Front Load

None

3.00%

Expense Ratio

0.15%

0.60%

Top Holdings

ExxonMobil, General Electric (NYSE: GE  ) , AT&T (NYSE: T  ) , Microsoft, Procter & Gamble

ExxonMobil, General Electric, AT&T, Microsoft, Procter & Gamble

3-Year Annualized Returns

3.55%

3.07%

Morningstar data as of Aug. 15, 2008.

As you can see, the difference in fees between these two funds with identical holdings makes a difference in returns received, even in as little as three years. Over a decade or more, we're talking about potentially missing out on thousands of dollars.

But it's even more unfortunate, as the Buffett example drives home, that paying high fees for actively managed funds can produce performance much worse than even a cheap, passive index fund.

Here are two funds for which investors paid handsomely, only to reap a net loss over the same time frame:

Fund Name

Boyar Value

Natixis Harris Associates Focused Value A

Front Load

5.00%

5.75%

Expense Ratio

1.75%

1.49%

Top Holdings

JPMorgan Chase, Travelers (NYSE: TRV  ) , McDonald's (NYSE: MCD  ) , Time Warner, Ameriprise Financial

Intel, National Semiconductor (NYSE: NSM  ) , PerkinElmer, Virgin Media (Nasdaq: VMED  ) , Robert Half International

3-Year Annualized Returns

(1.68%)

(2.63%)

Data from Morningstar as of Aug. 15, 2008.

All of the reasons above help explain why, in our Champion Funds newsletter service, we recommend mutual funds run by managers who outperform the market over the long term without charging you either an arm or a leg. Our average fund recommendation has an expense ratio of 0.92%, compared to the average domestic fund's expense ratio of 1.37%, and none of our picks have front-end loads. Collectively, they are beating the market by a double-digit spread.

If you'd like to browse through the cheap, money-making mutual funds we've elevated to Champ status, click here to try out the newsletter free for the next 30 days.

This article was first published June 26, 2008. It has been updated.

Adam J. Wiederman owns none of the shares mentioned above. Microsoft and Intel are Motley Fool Inside Value recommendations. JPMorgan Chase is an Income Investor choice. The Fool's strict disclosure policy is here.


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