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|Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.|
Warren Buffet's Million Dollar Bet against Active Investing
Ever since indexed funds were introduced in the 1970s, the debate over active vs. passive investing has raged on. At issue is whether actively managed funds, which charge higher fees for the expertise of money managers in picking stocks for the portfolio, can outperform low-cost, passively managed funds, which merely invest in stocks to track a particular index. Ten years ago, the world’s top investor, Warren Buffet, was so sure that active funds could not outperform passive funds that he bet $1 million to back up his claim. That was 2008 and, with just a few months before the ten years is up, it looks like he’s going to collect on his bet.
Buffet Lays Down the Challenge
Buffet, who has been investing since the early 1960’s, has never been coy about expressing his contempt for hedge funds, which are actively managed funds. In particular, he has complained about their high fees, which tend to reward the fund managers for nonperformance (fund managers earn 2 percent of the assets they manage regardless of how the fund performs). In a back and forth with one hedge fund manager, he claimed that an investment in an S&P 500 index fund could outperform a portfolio of hedge funds. The hedge fund, Protégé Partners, took him up on the challenge. The bet, which runs through the end of 2017, pits passive style investing directly against active style investing, with the winner donating the $1 million to a charity of their choice.
Practicing What He Preaches about Passive Investing
Although Buffet is an active investor himself, buying and selling stocks in his portfolio, he favors a long-term buy and hold strategy over more active trading. However, he has always advocated the use of passively managed funds for average investors because he sees them as the best way to achieve steady long-term returns. He contends, as do all of the advocates of passive investing, that the fees, costs, and expenses of active mutual funds make it very difficult for active fund managers to beat the market. So, if you can’t beat the market, you should at least become the market, which is essentially what index funds do. He has put his money where his mouth is by investing his grandchildren’s trust funds in index and exchange-traded funds.
And, the Winner Is…
With just a few months left, Buffet’s S&P 500 index fund is well ahead of the hedge fund portfolio, leading by more than 60 points. But it hasn’t been a smooth ride for the passive side. Just following the bet in 2008, the stock market crashed. The Protégé portfolio of hedge funds lost money, but Buffet’s index fund lost even more. It took four years for the index fund to catch the hedge fund portfolio and in the stock market’s continuous run up since, the index fund pulled ahead and kept the lead. Most active investing advocates say that the hedge fund portfolio did its job, by limiting the decline of its portfolio value during market downturns. Hedge funds are not meant to necessarily beat the markets; rather they are designed to generate above average risk-adjusted returns and outperforming during periods of market volatility. Protégé did do that, but it wasn’t enough to overcome a sustained bull market over 10 years which lifted the S&P 500 to record gains.
The bet is not likely to settle the debate, but Buffet did make a strong point. Investors pay tens of billions of dollars to active mutual fund and hedge fund managers each year for the sole purpose of beating the market indexes; yet, in the last 10 years, fewer than 25 percent are able to do it in most years. The ones who do manage the best the market rarely do so consistently. That means, if you had invested in an S&P 500 index fund over the last ten years, you would have beaten 75 percent of the active fund managers. The purpose of his million dollar bet was to bring awareness to average investors that fees and expenses matter and they would be better off joining the market rather than trying to beat it.
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