Warren Buffett believes that, over a ten-year period (or longer), the S&P 500 Index will perform better than most professional actively traded funds.
He believes this so strongly that he entered into a million-dollar bet with a group of professional hedge fund managers.
The bet ran from 2006 – 2016. Who do you think won?
Who is Warren Buffett?
I suppose there might be some people still who haven’t heard of Warren Buffett. If you fall into that camp, here’s a short bit of background.
Wikipedia does a good job with its concise description, so let’s just look at what they say about Warren Buffett:
“an American business magnate, investor, and philanthropist. He is considered by some to be one of the most successful investors in the world, and as of March 2017 is the second wealthiest person in the United States, and the fourth wealthiest in the world”
In other words, he’s a pretty smart guy who has shown consistent success in building wealth – both for himself and others. One of the most interesting facts about him is he’s all about simplicity. He’s not an active stock trader and he avoids complexity whenever possible.
This leads us to the million-dollar bet…
The million-dollar bet details
Warren Buffett believes that investing in a low-cost S&P 500 Index fund would be the smartest decision for most investors. He believes it so much that he picked a low-cost Vanguard mutual fund to put against a group of actively traded funds.
“Consistently buy an S&P 500 low-cost index fund, I think it’s the thing that makes the most sense practically all of the time.” – Warren Buffett in a CNBC interview
Buffett and the fund manager group each put up $500,000 for a cool million dollars – that will be donated to charity.
S&P 500 Index versus…
To make the bet even more interesting Buffett decided to let the fund managers pick five – that’s right, five – different funds that can all compete against the S&P 500 Index.
The funds they entered into the bet aren’t standard off-the-shelf funds. They are actually hedge funds that are limited to investments by high-net-worth individuals.
What is a hedge fund?
The team at NASDAQwrites “Well, simply put, a hedge fund is nothing more than an investment company that invests its clients’ money in alternative investments to either beat the market or provide a hedge against unforeseen market changes.”
In reality, a hedge fund uses highly risky techniques with the intention of protecting itself during downturns and producing better-than-average returns during bull markets. In any given year they can go way up, or way down. The plan is that over a longer time period – often stated as at least five years – the returns will normalize to better than investors can do on their own.
For this expertise and professional trading, hedge funds generally have really high fees. If you think the average mutual fund fee is bad, you won’t like these fees either. They can often run well over 2% per year.
Who is winning the bet?
At the end of 2016, we were nine years into the ten-year bet. Who do you think was ahead? Do you think it was a close race?
At the end of the ninth year, the Vanguard index fund logged a compound annual increase of 7.1% per year. Not bad. At that rate, you would double your money in 10 years. In fact, through the nine years, the fund was already up more than 85%. It was well on its way to potentially doubling!
How are the hedge funds doing?
The average of the five funds has produced a compound annual increase of 2.2%. No, that isn’t a typo. The average total gain of the five funds is right around 22%. Yes, almost 1/4 of the S&P 500 Index’s gain. The best of the five funds was up a total of around 63% – still way below the S&P 500 Index’s performance.
That’s embarrassing. For professional fund managers.
Actively managed funds – worth the cost?
By definition, an actively managed fund is going to have trading taking place. The professional managing the fund is always looking to pick investments that they believe are going to do well based on current (or estimated future) market conditions.
Since there is a lot of work that goes into constantly tracking the market and making trades, these fund managers charge pretty high fees. The average mutual fund (not a hedge fund) has a fee of around 1.5% annually.
If the returns of the funds were beating the market indexes by at least the level of fees, this might make sense. Unfortunately though, over the past 15 years, only about 10% of actively managed funds have beaten the indexes.
“The trick is not to pick the right company, the trick is to essentially buy all the big companies through the S&P 500 and to do it consistently and to do it in a very, very low cost way” – Warren Buffett
With the professionally managed funds doing so poorly, it makes you wonder what exactly you get for those high investment fees some advisors charge.
Should YOU invest in the S&P 500 Index?
Warren Buffett seems to think so.
I don’t think he’s wrong.
It is worth considering your overall portfolio mix though to make sure you get an appropriate level of return for the risks you’re willing to take.
Better yet would be to talk to a professional to make sure your investing lines up with an overall financial life plan.
As a fee-only financial advisor, I can help you clarify your dreams and priorities, then develop an actionable plan to achieve your goals. Having a financial plan for your life includes much more than just investing, but intelligent investing is definitely part of the solution. Just select Start Here and let’s talk about how I can help you maximize your money to achieve the life of your dreams.
Are you surprised that the Vanguard S&P 500 Index fund is beating out the professionally managed fund so much? Do you think the hedge funds have a chance of an EXTREME year in 2017 to make up the difference in the bet? Would you, or do you already, invest in an S&P 500 Index fund? Let us know in the comments below.
Haha!! I love this. I didn’t know about this but that is freaking embarrassing. I have been arguing with my companies 401K manager and he keeps telling me how great these 1.3% fee mutual funds are. I might have to share this with him. Indexing is absolutely the way to go. I just can’t believe more people don’t do it.
Actively managed mutual fund fees are insane – and don’t show any better results! Hopefully you’ll make some progress with your 401k manager to get some good low cost funds into the option pool. Thanks for stopping by Grant!
Haha I didn’t know about the wager. Safe to say besides a true miracle we’ll know who will be winning that bet. My sister in law still uses managers and she’s actually lost money (counting inflation) in the past 5 years.
Bummer about your sister in law. A really good financial advisor will place clients in low-cost investments, then they’ll do so much more than just investing – Cash flow, estate management, insurance analysis, etc, etc. I think *good* advisors are often worth the money – just not high-priced ones who claim to beat the market and only focus on investments. Thanks for commenting!
I think I read that the hedge fund guys were all too embarrassed to get exposed and only one guy was willing to put their money where the mouth was. It’s amazing that these guys don’t even believe in themselves enough to take it on. That should tell you everything that you need to know about these guys. If one of them was able to beat the market for 20 years that would have had money pouring into their accounts. But the risk of not being the market was too great. Just goes to show you that the S&P 500 is superior.
Thanks for stopping by MSM! Study after study shows that passive investing in low cost index funds beats out active management. I’ve been tricked into believing active management was better in the past – and it wound up being a big drag on my total portfolio returns. Never again!
Buffett is absolutely right. Most fund managers underperform, the index (it’s a fact). They’re so focused on short term performance that they can’t sit and ride a bull market. By getting in and out of a bull market, they misso it on a lot of gains.
I totally agree Troy!
I’d say that we have the majority of our 401(k), IRA, and brokerage accounts in passive index funds. I still have a few actively managed funds in my 401(k), most notably Fidelity Contrafund. The performance has been pretty good over the past 10 years and the expense ratio isn’t too crazy at around 0.55%
The Contrafund has annual expenses of .68%. Certainly not the worst out there, but not as good as a Vanguard Admiral fund of .04%. If it is beating the market by at least .64% (after taxes) then it sounds fine for you. A lot of people forget about taxes. Actively traded funds generate annual tax burdens way beyond what buy-and-hold S&P500 funds generate. Thanks for stopping by and sharing Mr. N2S!
Actively managed funds are not the way to go – I completely agree with Warren Buffet.
Thanks for sharing Brad
Thanks for stoping by Erik!
Watching out for the fund’s expense ratio is important, but don’t get hit with fees on the commission side either. Last I checked, Betterment had a .25% AUM fee, same with Wealthfront, and the “women’s version” Ellevest had a .50% AUM fee! Doesn’t seem like much, but subtract it from your returns and compound it and you can lose 5-15% of your returns that way, easily tens of thousands of dollars over your investing life. And some in-person financial advisers will charge 1.5% AUM themselves! Index funds are great- don’t undo their benefits by choosing the wrong adviser.
Absolutely MwM – gotta watch those fees! Betterment has the lowest fees of the automated platforms, so is a good option for non-DIY investors. Beyond that, using Fidelity, TD Ameritrade, etc. is a good solution for full DIY investors. Thanks for stopping by!