Warren Makes a Bet

By John Mauldin
FrontLineThoughts.com

The Sage of Omaha made a bet that was written up in a recent Fortune magazine article. Basically, Warren Buffett bet that the S&P 500 would outperform a group of funds of hedge funds over the next ten years. A million dollars to someone’s favorite charity is on the line. This week we will analyze the bet, using it as a springboard to learn about valuation and value investing. As we will see, there are times that making a bet on the S&P 500 to outperform hedge funds (or bonds or real estate or whatever asset class) makes sense and times when it doesn’t.

Warren Makes a Bet

Carol Loomis (one of my favorite financial writers) writes in this week’s Fortune about a bet that Warren Buffett made with a hedge fund management company. You can read the fascinating story

Quoting:
“And to that there is a certain history, which began at Berkshire’s May 2006 annual meeting. Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn’t been taken up on the bet, he must be right in his thinking.”

A New York firm, Protégé Partners, which manages $3.5 billion in a fund of hedge funds, decided to accept that bet. Basically, Buffet and Protégé each put $320,000 into 10-year zero-coupon Treasury bonds that will be worth $1 million in 10 years. The bet is straightforward. Protégé has chosen five funds of hedge funds, and these funds must return more than the S&P 500 over the 10 years beginning January of 2008. (The list of funds is a secret.) The winner gets the $1 million donated to their favorite charity.

Which way would you bet? If the online response at Fortune is any indication, 90% of you would bet with Warren. As one enthusiastic responder wrote, “How can you bet against Buffett? I’d bet my life savings on it …” Well, Tom, you might want to hedge your bet. Even Warren said he thinks his odds are only 60%.

The basic premise to Buffett’s position is that the high fees simply eat up any potential for extra profits, over those of a simple index fund. As Buffett writes:

“A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.”

And he is right about the fees. Hedge funds, and especially funds of funds, must do much better than average to overcome their high fees. Loomis sums it up as follows:

“As for the fees that investors pay in the hedge fund world – and that, of course, is the crux of Buffett's argument – they are both complicated and costly. A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

“So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones ‘bought’ by Buffett in the bet.

“On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the ‘helpers’ that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

“The summation is pretty obvious. For Protégé to win this bet, the five funds of funds it has picked must do much, much better than the S&P.”