Why I Lost My Bet With Warren Buffett
Nine years ago, Warren Buffett and I made a 10-year charitable wager that pitted the returns of five funds of hedge funds against a Standard & Poor’s 500 index fund. With eight months remaining, for all intents and purposes, the bet is over. I lost.
Warren discussed the bet in this year’s annual letter to Berkshire Hathaway Inc. shareholders, explaining that the high fees active money managers charge create a headwind relative to low-cost passive alternatives. He is correct that hedge-fund fees are high, and his reasoning is convincing. Fees matter in investing, no doubt about it.
It’s just not the whole story.
This “footnote” to his letter describes some of the additional investment lessons we can draw from our experiment.
No. 1. Price matters … eventually
The higher the price an investor pays for an asset, the less he should expect to earn. When we made the bet in 2008, the S&P 500 traded at the high end of its historical range. Probabilities strongly suggested the S&P 500 would generate low returns in the future, which would have helped the relative performance of hedge funds.
But the S&P 500 defied the odds and rewarded investors with a historically normal 7.1 percent nine-year annualized return. Part of that return came from investors’ willingness to pay more for a dollar’s worth of earnings, leaving the index trading at an adjusted 29 times its average earnings during the past decade. A high starting price didn’t translate to low returns during this period, but investors should be cautious extrapolating that outcome to the future.
No. 2 Risk matters … eventually
Good investment decisions incorporate a comprehensive assessment of the trade-off between reward and risk. Our bet focused on returns, casting aside the degree of risk assumed in earning those returns.
Warren and I have written during the past two years that he will win the bet absent a market crash. Hedge funds tend to significantly outperform in bear markets, as demonstrated in 2008 and 2000-2002. These same risk-mitigating properties tempered hedge-fund returns in the rally that began in March 2009.
Although a market crash is highly unlikely in the near future, a consideration of risk as well as return changes the debate as we draw conclusions about the last decade and look forward to the next one.
No. 3. A passive investment in the S&P 500 is an active bet
Passive investing is the rage today, and the S&P 500 is the most popular index. During the last nine years, the S&P 500 outperformed most other investment options. All too often, those two facts go hand in hand; investors tend to chase returns.
Choosing the S&P 500 as representative of the market isn’t as simple as it may appear. The S&P 500 is a strategy that is concentrated in the largest U.S.-listed stocks. Compared to more diversified, low-cost passive investments, the S&P 500 is biased toward U.S. stocks relative to global stocks and large companies relative to small ones. These two bets generated anomalously strong relative performance in this period.
No.4. Be careful comparing apples and oranges
Comparing hedge funds and the S&P 500 is a little bit like asking which team is better, the Chicago Bulls or the Chicago Bears. Like the Bulls and the Bears in the Windy City, hedge funds and the S&P 500 play different sports.
Hedge funds are not limited to investments in large U.S. stocks, and professional investors in hedge funds don’t use the S&P 500 as their benchmark. Warren’s description of active managers necessarily underperforming as a group by the amount of fees charged is precisely true when the active managers’ investment universe is identical to the passive alternative. In this bet, it wasn’t.
It was global diversification that hurt hedge fund returns more than fees. In fact, a low-cost index of large global companies, the MSCI All Country World Index, almost exactly matched hedge-fund returns during the same nine-year period of our bet (and international stocks actually lost money during that period.) This index isn’t a perfect benchmark for hedge funds either, but it is a lot closer to an apples-to-apples comparison than hedge funds and the S&P 500.
Forget the Bulls and Bears; Warren picked the World Series Champion Chicago Cubs! His excellent choice of the S&P 500 for the bet was the main reason he won.
No. 5. In investing and in life, we live through only one experience out of many possibilities
Imagine a game of Texas Hold ’em poker. Two players bet “all-in” after seeing their two hole cards before the flop. The one with the stronger hand is the odds-on favorite to win. If the players repeat an identical game over and over again, the favorite will win the hand most of the time. But if they play only one hand, anything can happen. The player with the better cards may lose even if he “should” win.
The unexpected strength of the S&P 500 was a key contributor to Warren’s victory. Despite trading for a high multiple of earnings and facing an elevated level of risk, the S&P 500 performed in-line with historical averages. However unlikely that outcome may have seemed nine years ago, it is the only one that played out.
No. 6. Long-term returns only matter if we invest for the long term
Studies of human behavior repeatedly point to the inability of investors to stay the course through tough times. The S&P 500 had a harrowing start to the bet in 2008. In October of that year, Warren publicly made a prescient market call, reminding us to be greedy when others were fearful.
The S&P 500 index fund fell 50 percent in the first 14 months of the bet. Many investors lacked Warren’s unparalleled fortitude, and bailed out of the markets when the pain became too severe. An investor who panicked and only later re-entered the market would have found that his bank account at the end of the bet was a lot smaller than a hypothetical account in which he earned the index-fund returns for the whole period.
The valuation declines hedge funds experienced in the crisis were less than half those of the S&P 500. As a result, hedge-fund investors stood a much better chance of staying the course and earning the returns on the rebound, even if those returns were less than those of the index fund.
My guess is that doubling down on a bet with Warren Buffett for the next 10 years would hold greater-than-even odds of victory. The S&P 500 looks overpriced and has a reasonable chance of disappointing passive investors. Hedge funds mitigate risk in bear markets, while seeking to participate in some of a bull market. Investing in hedge funds is a bet against continuing bull markets; investing in the S&P 500 is a bet on a continuing bull market.
The late Peter L. Bernstein, author of “Against the Gods: The Remarkable Story of Risk,” wrote that risk means we don’t know what will happen. A passive investment in the S&P 500 isn’t a sure thing, and that uncertainty creates the rationale for portfolio diversification. Fees will always matter, but market risk sometimes matters more.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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