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The Truth Behind Buffett's Big Bet

By Adam Wiederman - Updated Nov 11, 2016 at 4:55PM

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The Oracle of Omaha bet against top fund managers.

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:

 

Vanguard 500 Index

MainStay S&P 500 Index A

Front Load

None

3.00 %

Expense Ratio

0.15%

0.60%

Some of Top 25 Holdings

Philip Morris International (NYSE:PM), Wells Fargo (NYSE:WFC), Hewlett-Packard

Philip Morris, Wells Fargo, Hewlett-Packard

3-Year Annualized Returns

(9.98%)

(10.37%)

Morningstar data as of Dec. 3, 2008.

As you can see, the difference in fees between these two funds with identical holdings makes a difference in losses felt, 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 far worse than even a cheap, passive index fund.

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

 

Boyar Value

Natixis Harris Associates Focused Value A

Front Load

5.00%

5.75%

Expense Ratio

1.75%

1.49%

Some of Top 25 Holdings

United Parcel Service (NYSE:UPS), Microsoft, MGM Mirage

Advance Auto Parts (NYSE:AAP), Legg Mason (NYSE:LM), Discover Financial Services (NYSE:DFS)

3-Year Annualized Returns

(13.26%)

(19.77%)

Data from Morningstar as of Dec. 3, 2008.

All of the above reasons help explain why, in our Motley Fool Champion Funds newsletter service, we recommend mutual funds run by managers who outperform the market over the long term without charging you an arm and a leg. Our average fund recommendation has an expense ratio of 0.93%, compared with the average domestic fund's expense ratio of 1.11%, and none of our picks has a front-end load. Collectively, they are beating the market by just less than 10 percentage points.

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 shares of Legg Mason, but of no other company mentioned above. The Motley Fool also owns shares of Legg Mason. Discover Financial, Legg Mason, and Microsoft are Motley Fool Inside Value recommendations. United Parcel Service is an Income Investor pick. The Fool's strict disclosure policy is here.

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Stocks Mentioned

Wells Fargo & Company Stock Quote
Wells Fargo & Company
WFC
$45.25 (2.08%) $0.92
United Parcel Service, Inc. Stock Quote
United Parcel Service, Inc.
UPS
$204.43 (1.02%) $2.06
Discover Financial Services Stock Quote
Discover Financial Services
DFS
$108.51 (0.49%) $0.53
Legg Mason, Inc. Stock Quote
Legg Mason, Inc.
LM
Advance Auto Parts, Inc. Stock Quote
Advance Auto Parts, Inc.
AAP
$197.42 (1.40%) $2.73

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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