Buffett’s million dollar bet: Index Funds and Hedge Funds

January 31st, 2013

Warren Buffett and Funds

With Warren Buffett’s opinion of hedge funds, it is a surprise (well, perhaps not, because he is a contrarian) to see that several of his possible successors all come from hedge funds.

Buffett has often said that investors, particularly small ones, who do not have access to the financial expertise and information that he has, or who just want to invest without a lot of thought, would be better off putting their money in an index fund than in picking stocks themselves or running up high fees in mutual funds. Buffett has said that:

A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money funds …. The gross performance may be reasonably decent, but the fees will eat up a significant percentage of the returns …. You’ll pay lots of fees to people who do well, and lots of fees to people who do not do so well.

Charlie Munger has been even more scathing in his criticism of managed funds, essentially accusing them of lying about their returns, basing their forecasts on past performance that may have been good in the early years after they were formed and were smaller and better managed.

Successful funds attract a massive amount of money, and the later performance typically gets mediocre …., then they keep publishing returns for the whole period for someone who started 20 years ago…. The reporting has falsehood and folly in it.

What is an Index Fund?

An Index Fund puts investor funds in a broad range of investments in a particular category. So the Vanguard 500 Index Fund invests in the top 500 companies in the Standard and Poor Index. They then buy shares in each company in that Index in the proportion that the total value of that company bears to the total value of all the companies in that Index.

So, if company X had a market value of $1 billion dollars and the total market value of the 500 companies in that index fund was $100 billion,  that is 1 per cent (1 times 100 divided by 100), the fund managers would invest 1 per cent of the Index funds in the shares of that company.

Because the fund managers do not have to make investment choices based on their own research and judgment, the costs of administering the fund is far less than with mutual funds, which means lower commissions charged to investors. The only action required of the fund managers is to ensure that, in a changing market where the value of individual companies rises and falls, they adjust the fund’s holdings to approximately reflect the real position.

Buffett”s argument, and Munger’s is, that fees and administration costs deducted from the fund member’s investment means that there is less money to invest. For example, if you put $100 into a mutual fund and the fund manager charges 2 per cent to go into the fund, there is only $98 left to invest and you are behind in your investment from the start. So the fund then has to get you your $2 back to put you in your original position, which means that it has to show a profit of $2.04. If it then charges you an annual management fee of 5 per cent (as some mutual funds do), this too has to be earned. So, at the end of the first year, your fund needs to be 7.04 per cent ahead just to put you in your original position. But it needs to be further ahead than that because you could have put that interest in a bank instead of the fund and earned interest. Index funds generally do not bear an entry or exit fee and annual management fees rarely exceed 1 per cent.

Buffett’s Million Dollar Bet on Index Funds

In 2008, Buffett backed up his opinion as to the comparative merits of index funds and other funds with a million dollar bet with Protégé Partners LLC. He bet that the return on Vanguard Admiral, based on an index of the Standard and Poor 500,  would outperform over ten years an index of five funds that invest in hedge funds.

At the half way mark (January 2013), Buffett’s horse is well in front with a return of 8.69 per cent against the hedgers’0.13 per cent. The hedge funds had jumped to the front in the aftermath of the crash of 2008 but have more than come back to the field.

The $1 million dollars will go to a children’s charity selected by the winner.

Posted by Julian Livy on January 31st, 2013 | Posted in Warren Buffett |