Post #4 Bet of the decade

Can laziness be a virtue? According to Warren Buffett: benign neglect, bordering on sloth, is the hallmark of his investing style.

And to put his money where his mouth is, in 2008, he issued an open challenge to the hedge fund industry, which in his view charged exorbitant fees that the funds' performances couldn't justify.

Protégé Partners LLC accepted his challenge, and tada! the world got to witness a high stakes bet that lasted a decade.

Buffett's reasoning

• A lot of very smart people set out to do better than average in securities markets. Call them active investors.

• Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund.

• Therefore the balance of the universe—the active investors—must do about average as well. 

• However, these active investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.

Protégé Partners reasoning

• Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment.

• For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times.

• Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.

The result?

The five hedge funds (these were funds-of-funds selected by Protégé Partners) got off to a fast start, each beating the index fund in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund. 

The S&P averaged 8.5% CAGR (Compounded Annual Growth Rate) over the decade but the CAGRs of the hedge funds were far worse: 2.0%, 3.6%, 6.5%, 0.3% and 2.4% respectively.

Source: Buffet's letter to shareholders, 2017

The lesson?

• It is **very hard** to beat a low cost index fund over long periods of time.

• There are three connected realities that cause a money manager's investing success to breed failure. 1.) a good record quickly attracts a torrent of money. 2.) huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). 3.) most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees.

• The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

That's all for now folks! Take care and have a good day. ❤️