Just over 9 years ago, Mr. Warren Buffett made a $1M bet with the asset manager from Protégé Partners that his chosen index fund could outperform their chosen group of hedge funds over 10 years. Come December 31st of this year, it looks like Buffett will win his bet.
Study after study has shown that most hedge fund managers rarely outperform their benchmark index funds and if they do, it doesn’t last very long.
Index funds that invest in, as an example, every single stock in the S & P 500, will outperform as many as 97% of the fund managers who choose and trade their own stock portfolio. The irony is that Buffett has actually outperformed his own benchmark index funds himself, but he is the exception to the rule.
Two Nobel Laureates, Eugene Fama and Kenneth French, did an extensive study on index funds versus actively managed funds in the stock market. They found that only 2% out of 3,156 fund managers had what they called “significant evidence of skill” and that a low-cost index fund is likely to outperform 97% of managed funds within the same markets.
Some will argue that this is too much of a blanket statement and some fund managers do outperform their benchmark index funds for years. Even so, don’t be fooled into thinking it’s easy.
How are you going to pick those winners when the professionals struggle to do it?
What all this tells me is that the average investor is subject to the whims of the market’s ups and downs with very little control. Rising tides raise all ships but remember, the opposite is true with falling tides.
The only way the professionals could consistently beat the very efficient stock market would be to have that “significant evidence of skill” like Buffett or the 2% found in the study.
One of the other reasons fund managers don’t win the race of performance is the higher fees that need to be charged to pay for staff and overhead to manage a fund. Index funds usually cost less, therefore giving them an automatic advantage. Buffett chose the Vanguard 500 Index Fund Admiral Shares, which has a low-cost fee structure.
How will Buffett spend his $1M win? It will go to the Girls Inc. of Omaha, Nebraska charity. And if Protégé Partners pulls out a miracle by the end of the year, their winnings will go to Absolute Return for Kids.
True to form, Buffett didn’t just take the bet without preparing and investing for it. He stashed away $320,000 into bonds, expecting them to appreciate to $1M by the end of the 10-year betting period. However, those bonds appreciated faster than expected as interest rates fell. So, Buffett decided in 2012 to buy 11,200 shares of Berkshire B. That was a good decision. Buffett has done it again by turning $320,000 into $1.9M as of mid-February, 2017.
So, why is it so difficult for even the smartest fund managers to beat the market overall?
When you can know the cost of stock down to the penny within seconds, that is efficient. Everyone knows generally the same information all the time, so competition is high.
That is why it is easier to make more money, with less volatility and risk in inefficient non-traditional markets. All of Hughes Private Capital’s funds fall into this category. Our newest fund, Guardian, is a perfect example. The markets we invest in are inefficient and difficult to obtain the right information to be successful unless you have the sources, expertise, and skills. This gives us a tremendous advantage over our limited competition. As we have learned over time, inefficient markets are your friend and the more inefficient they are, the better.
Here is another way to think of it, “Good deals are made, not found.” Anyone up for a $1M bet?