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BUFFETT: This is the most important investment lesson in the world

Index funds vs. Hedge funds

Nearly a decade ago, Warren Buffett made a million-dollar bet: that by investing in a completely unmanaged, broad-market low-fee index fund, he could beat the gains earned by a high-powered hedge fund with a team of managers at the helm. His opponent was Protege Partners, LLC, a New York City hedge fund with $3.5 billion in assets under management.

Hands were shaken, the stakes were set (a $1 million donation to the winner’s charity of choice) and the clock was set for 10 years.

With less than two years to go before the bet expires on Dec. 31, 2017, Buffett was already celebrating at the Berkshire Hathaway (BRK) annual shareholders meeting held in Omaha last weekend.

His simple Vanguard S&P 500 (VFINX) fund has delivered returns more than 40 points higher than those of the hedge fund. “I believe this is the most important investment lesson in the world,” he said.

Despite an initial stumble in 2008, when the index fund was down 37% vs. the hedge fund’s 23.9% loss, the former rebounded in astounding fashion. In its best year, 2013, the broad market index fund saw 32.3% gains vs. the hedge funds’ 11.8%. In fact, his index fund beat the hedge fund’s returns in 6 out of 8 years.

At the end of 2015, Buffett was up 65.7% vs. their 21.9%.

Not shabby, Buffett.
Not shabby, Buffett.

They don’t call him the world’s greatest investor for nothing, but Buffett wasn’t only there to gloat (alright, maybe just a little). He went on to explain exactly why he decided to take on the managed investment industry. It wasn’t that hedge fund managers are bad at picking investments, but because the fees they charge for their trouble — 2%-3% of annual returns is common —  totally kill their clients’ returns. The Vanguard 500 Index Fund has a 0.16% expense ratio.

“[Losing by 40 points] may sound like a terrible result for the hedge funds, but it’s not a terrible result for the hedge fund managers,” he said. “If you have a couple percentage points sliced off every year, that is a lot of money ... It’s a compensation scheme that is unbelievable to me and that’s one reason I made this bet.”

Buffett has long advised his followers to stick to low-cost, passive index funds, which can offer broad exposure to the stock market and cost a fraction of actively managed funds (generally half a basis point or lower). His faith in the American economy is as strong as ever, despite the crushing blow the 2008 financial crisis dealt to millions of dutiful savers.

“It’s so obvious and yet all the commercial push is telling you you ought to do something different today than you did yesterday,” he said. “You don’t have to do that. You just have to sit back and let American industry go to shop for you.”

The performance of the Vanguard 500 – which simply tracks the performance of the S&P 500 index – backs up what research has shown in the years since the recession: that people who kept their money in the market have fared much better than those who cashed out and stood on the sidelines. He blasted investment advisors who try to convince clients otherwise.

“No consultant in the world is going to tell you just buy an S&P index fund and sit for the next 50 years,” he said. “You don't get to be a consultant that way and you certainly don’t get an annual fee that way.”

More wisdom from Buffett:

Don't play the stupid IPO game 

Buffett's 7 best pieces of investing advice

18 lessons from Buffett on finances, life and finding a job you love