Warren Buffett's famous $500,000 bet that an S&P 500 index fund would beat a basket of hedge funds over a 10-year period is about to come to a close. However, Buffett recently said that he is more than willing to repeat the bet if anyone is particularly confident in the hedge fund industry over the coming decade.
Here's why Buffett is so certain that a simple index fund will perform better than a group of professional investment managers.
Buffett's original bet is about to pay him millions
A little over a decade ago, Warren Buffett publicly offered to wager $500,000 that no professional could select a group of at least five hedge funds that would match the performance of a low-cost S&P 500 index fund that simply tracked the market's performance over a period of 10 years.
The only person to accept Buffett's bet was a man named Ted Seides, who chose a basket of five funds-of-funds (funds that invest in multiple hedge funds). These funds are made up of more than 100 different hedge funds, so the funds' results won't be too reliant on any single manager's performance.
Well, the bet is in its last year, and it's not even close. In fact, Seides has already conceded defeat. Buffett's S&P 500 index fund has generated nearly four times the returns of Seides' funds-of-funds portfolio. The original pot of $1 million was invested in Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) stock -- which is worth significantly more now -- and Buffett's winnings will be donated to charity once the 10-year bet is officially over.
Was it a fluke? Buffett doesn't think so
Some hedge fund professionals say that Buffett simply got lucky with the timing. The market has gone up steadily since the bet was made, and many people argue that hedge funds are better equipped to make money in down markets.
Buffett doesn't buy this logic. In fact, he is willing to make the same wager again over the next 10 years, if anyone will take the bet.
In a recent CNBC interview, Buffett said, "The date of the start has nothing to do with it." He also said that passive investing works in any environment, especially against a fund-of-funds.
Buffett is offering to repeat the bet if anyone is willing to put up "a significant percentage of their net worth." So if you believe that hedge funds will outperform the market as a whole over the next decade, here's your chance to try to win some of Warren Buffett's money.
Why does Buffett believe index funds will always beat professionally managed hedge funds?
To be clear, Buffett isn't saying that an S&P 500 index fund will beat every hedge fund over the next decade, or during any other 10-year period for that matter. What he's saying, rather, is that a group of hedge funds is almost guaranteed to lose to the market over long periods of time.
His main reasoning concerns the fees charged by hedge funds. Buffett says that, as a whole, hedge fund managers' investments should roughly match the market's performance. Some managers will pick winners, others will pick losers, and it will all balance out in the aggregate.
The hedge fund industry standard fee structure is known as the "two and 20," which means a 2% annual fee that is paid to managers no matter what, and 20% of profits in years where the fund makes money. So you have an investment product where the underlying holdings can be roughly expected to match the market's performance, and you're deducting massive fees from it.
The same logic can be applied to actively managed mutual funds or any other high-fee investment product. Buffett's logic is that most investors are simply better off buying low-cost index funds that guarantee investors that they'll match the market's performance, with minimal fees deducted from the returns.
Should you invest in index funds?
To be clear, Buffett isn't saying that index funds are necessarily a better investment than individual stocks. Buffett has made his fortune by choosing individual companies to invest in, and if you have the time, knowledge, and desire to research and evaluate individual stocks, we encourage you to do it.
On the other hand, for the majority of Americans who don't have these attributes, Buffett is making the point that fees are the enemy of American investors, and those who simply avoid fees and invest in the market's performance will do just fine over time. Those who invest in high-cost funds will likely only succeed in making the fund managers rich.