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🦉 Warren Buffett vs Wall Street
the story of a million dollar bet
Al Atencio
October 23, 2024 • Estimated Reading Time: 10 minutes
We imagine that the most sophisticated professional investors have an edge in the returns over what any regular Joe investor can achieve.
But seventeen years ago, Warren Buffett made a public bet that they didn’t.
He predicted that a simple S&P 500 index fund would outperform any active fund manager over the following decade.
He was so confident that he made a $1 million dollar bet for any takers.
Let me tell you what happened and why the details of this story contain one of the most valuable lessons you’ll ever learn as an investor.
the bet
I figured the Wall Street hotshots would be lining up to prove me wrong. I mean, these guys were convincing people to bet billions on their supposed skills. Surely they'd jump at the chance to put their own money where their mouth was, right?
Surprisingly, only one contender, Ted Seides, then co-manager at Protégé Partners, took on the bet.
Seides was a seasoned institutional investor. He had started his career in 1992 at the Yale Investments Office, working under the legendary David Swensen. Swensen, was a revered figure in finance, whose investment decisions grew Yale's endowment from $1.3 billion to over $31 billion.
After Yale, Ted had studied at Harvard Business School, and later co-founded Protégé Partners. Where he served as president and co-CIO, and focused on hedge fund investments.
Ted Seides and Warren Buffett
The bet: Each side put $500,000 into their chosen investment strategy. The winner would be whoever made the most money over ten years.
Buffett's choice was a low-cost fund that tracks the S&P 500 index.
Why did Buffett pick the S&P500?
The S&P 500 index tracks the performance of the roughly 500 largest publicly traded companies in the US. These aren't just any companies – they're the heaviest hitters out there - representing about 80% of the total value of publicly traded US stocks.
If you want to bet on US (and world) capitalism, this is what you buy.
“In my view, for most people, the best thing to do is own the S&P 500 index fund”.
The Hedge Funds
To beat Grandpa Buffett, Ted Seides put together a handpicked group of five hedge funds.
But not just five individual funds - he picked five “funds-of-funds.” A fund-of-fund invests in a collection of other funds.
Seides, who knew his way around Wall Street, picked the best five investment fund managers he knew; these managers, in turn, were betting on the top hundred investment pros they knew—each running their own hedge fund.
It was like he was assembling a massive elite squad.
As active investors and fund-of-funds managers they had potentially had one big advantage. They were free to chase after the hottest new fund managers, and whatever they were investing in, and ditch any funds that started to underperform.
Whereas Buffett had to stick to the S&P500 for the entire ten-year stretch.
and… we are off
The timing of the bet couldn’t have been worse for Buffett. The first year coincided with the start of the Great Financial Crisis (2007-2009), the deepest bear market since the Great Depression.
The S&P500 had a maximum drawdown of 57%.
Hedge funds which can go long and short, and do other complex strategies, had a clear advantage during such a major market crash.
That first year they beat the S&P 500 bigly.
For Buffett, going long on US equities right as the market collapsed was like an investor’s worst nightmare.
To make a long story short
In the remaining nine years of the bet, it was a neck-to-neck competition.
Finishing in a photo finish.
With the funds managing to beat the SP500 at the end.
Actually, the S&P500 absolutely crushed the hedge funds.
It beat the them in every single one of those remaining nine years.
By a big margin.
Skadoosh baby.
image: Kung-Fu Panda
Here is the final picture of the race:
Source: Berkshire Hathaway Annual Report (2017)
The S&P 500 delivered an average annual return of 8.5%, compared to the hedge funds' 2-3% return.
In money terms:
$1 million invested in the funds would have generated $220,000 in profits
$1 million invested in the SP500 earned $854,000 in profits.
takeaways
Don’t believe the hype
There are plenty of professional money managers that beat the market any given year or over a short period.
But over the long-term its a tiny few.
“There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat.”
And this is coming from one of the few people ever to do it.
And the data is pretty clear: According to the S&P Dow Jones Indices, over a 10-year period around 90% of fund managers undeform the market.
Accepting this fact, will be one of the most important investing lessons you can ever make.
Trust me.
Think about this for a minute next time somebody pitches you an equity investment that’s “guaranteed to beat the market”.
And if they are such hot shit why are they asking for your money?
Which brings us to the big question:
If the pros can’t beat the market how do they earn so much money?
Fees, fees and AUM
The fund guys typically charge a 2% annual fee (no matter how badly they do) plus 20% of profits.
For fund-of-funds, there's an extra layer of managers and fees.
Which means that for an investor to earn above-market returns, there is a double challenge:
Not only does the manager have to beat the market, but they also have to do it by a wide enough margin to cover the fees.
The truth: The majority of professional equity managers deliver sub-optimal returns to their investors - compared to what they can get with passive investments.
They know it.
But as long as they can pitch their products well and grow assets under management they become rich.
“On the basis of my long and broad acquaintance with professional managers, I am convinced that many of them have made their fortunes from the fees they earn from their clients rather than from investing their own money.”
They are not going to give you advice that doesn’t benefit them.
“Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500?
That would be career suicide.
Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.
The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive.”
S&P500 and chill?
Investing is not as simply going all-in the S&P500 and that’s it.
Although if you would have done it that for the last 15 years you would have made a lot of money. 6x your money.
But then the decade between 2000 and 2009 the S&P500 was almost flat. While international equities soared. That’s why people recommend diversifying.
There is diversification both within an asset class, buying US as well as international equities, and diversifying into other asset classes, fixed income, and so on.
Once you’re managing a larger portfolio, say over $5 or $10 million, it makes sense to explore alternative asset classes and more complex strategies. Then there’s the matter of rebalancing, optimizing for taxes, negotiating with banks, and managing fees.
But if all you wanted to do for the next 30 years is invest in the S&P500 and did nothing else, and have the strong stomach to hold on, you will come ahead of the large majority of other investors.
As long as capitalism rules the world economy and the US is the epicenter of capitalism and entrepreneurship then this is almost guaranteed to happened.
And if you don’t believe me, go ask Grandpa Buffett.
quote
I was in Minnesota and I was buying a fishing lure.
And I looked at them and they were pink and green and so I asked the shopkeeper, do fish really take this lure?
And the old-timer behind the counter said, Mister, I don't sell to fish.
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