Warren Buffett won his bet, and mainstream investors could be a bit better off — or at least more knowledgeable — because of it.

The billionaire from Nebraska revealed the final results of his 10-year investment bet, in which he wagered that a humble stock-market index mutual fund could beat some of the brightest money managers on Wall Street.

The results weren’t much of a surprise, considering that Buffett last year revealed that he held a commanding lead. Both disclosures were made in his annual letters to shareholders as chairman of conglomerate Berkshire Hathaway.

Buffett made the bet in December 2007, arguing that a fund holding the same stocks as found in the Standard & Poor’s 500 index could beat the combined performance of a group of hedge funds over the following 10 years.

Hedge funds are investment partnerships that cater to wealthy individuals and institutions. They charge high fees for their supposed financial acumen.

Buffet gave a progress report a year ago, following year nine. In late February 2018, he provided the final results.

“Now I have the final tally — and in several respects it’s an eye-opener,” he wrote in his newly released Berkshire Hathaway letter to shareholders. Results from the S&P 500 index fund easily beat the hedge-fund rivals.

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Buffett made the bet to publicize his conviction that a “virtually cost-free investment” in an S&P 500 index fund, available to anyone with a few hundred or a couple thousand dollars to invest, would beat the results achieved by high-end professional money managers.

Many of those managers restrict their services to millionaires and big institutions such as pension funds and college endowments

“American investors pay staggering sums annually to advisers, often incurring several layers of consequential costs,” Buffett wrote. “Do these investors get their money’s worth?”

‘Brains, adrenaline and confidence’

Buffett said he placed the bet with Protégé Partners, which picked five hedge “funds of funds” that aimed to outperform the broad market, as represented by a simple S&P 500 index mutual fund.

Those five funds of funds together owned stakes in more than 200 hedge funds, providing a broad sample of money managers with different investment strategies. (Buffett agreed not to disclose the funds’ names. Protege didn’t respond to a request for comment.)

Hedge funds are run by some of the most highly compensated people on Wall Street. 

“This assemblage (of hedge-fund managers) was an elite crew, loaded with brains, adrenaline and confidence,” Buffett wrote.

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The managers of the five funds of funds had another advantage, Buffett argued.

“They could — and did — rearrange their portfolios of hedge funds during the 10 years, investing with new ‘stars’ while exiting their positions in hedge funds whose managers had lost their touch.”

Index funds, by contrast, typically don’t add or drop stocks all that often. Changes happen fairly infrequently, as when corporations sell shares to the public for the first time, get acquired, go private or fall below a certain size or other threshold.

The final results of the bet, according to Buffett, provided a resounding victory for low-cost index funds over high-cost hedge funds. The returns over the 10-year period for the five hedge funds of funds ranged from a mere 0.3 percent to 6.5 percent annually. 

A representative S&P 500 index fund generated an 8.5 percent annual return.

Costs are crucial

Why the difference? The higher investor-borne expenses charged by hedge-fund managers likely were key. Hedge-fund managers don’t merely take a share of the overall capital gains (in the range of 20 percent) but charge sizable ongoing expenses averaging 2 percent or so yearly.

That’s in comparison to typical index-fund fees of around 0.2 percent, if not lower.

Trading activity and poor decisions by managers also likely played a role. 

By holding a fairly steady mix of stocks through thick and thin, index funds don’t run the risk that a manager could make glaringly bad judgment calls like selling stocks right before a market surge.

“During the 10-year bet, the 200-plus hedge-fund managers that were involved almost certainly made tens of thousands of buy and sell decisions,” often responding to short-term market gyrations or inconsequential news, Buffett observed. 

What investors need instead is “an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals,” he said.

Buffett criticisms

Buffett’s analysis doesn’t sit well with numerous investment companies that employ legions of money managers who actively strive to beat the market by selecting what they consider the most promising stocks.

Timothy Armour, chairman and CEO of Capital Group, which oversees the American Funds family, responded in his own letter to investors that his company has many actively managed mutual funds that have beaten representative indexes over time.

Citing Buffett, Armour decried what he called the common myth that it’s “impossible” for an investment manager to beat an index.

The American Funds do feature active managers — meaning professionals who try to select stocks they feel are likely to outperform, unlike index funds that maintain mostly stable portfolios.

But in other ways, portfolios in the American Funds group resemble index funds, which ironically explains much of their success.

In particular, the company’s actively managed funds, like index funds, feature broad diversification, a propensity to stay fully invested, a long-term focus and modest shareholder-borne costs, averaging about 0.5 percent annually for the portfolios Armour cited.

Clearly, it’s not impossible for active fund managers to beat an index. But the odds are against that happening, and it is difficult for investors to predict which managers will get the job done. 

Buffett is warranted in his enthusiasm for index funds and in his criticism of high-cost alternatives.

Reach Wiles at [email protected] or 602-444-8616.

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