Not since the fictitious Duke Brothers of the movie Trading Places has a bet captured the imagination of investors like the one between Warren Buffett and hedge fund manager Ted Seides. But unlike the $1 wager between Mortimer and Randolph, Buffett and Seides have a lot more money at stake.
Although he’s considered the greatest stock picker of all time and Berkshire Hathaway (BRK-A, BRK-B) is up 2,500% in the past quarter century alone, Buffett is betting on his belief that hedge funds can’t beat an index fund. And so far, Buffett is winning big.
A little more than eight years ago, Seides accepted Buffett’s challenge and picked a group of five hedge funds that he expected to collectively outperform an index fund chosen by Buffett. The winner would get $1 million donated to a charity of his choice. Each man put $320,000 in bonds (for a total of $640,000) that were supposed to mature to $1 million by 2018. But with the rally in bonds, they're worth closer to $1.4 million today.
Buffett’s S&P 500 (^GSPC) index fund, the Vanguard 500 Index Fund Admiral Shares (VFIAX), is trouncing the hedge funds. It was up nearly 66% from the time the bet began until the end of 2015, a return of about three times that of the funds chosen by Seides despite the fact that the index underperformed the hedge funds last year. The names of the hedge funds have not been released to the public.
Wall Street legend Jack Bogle, the Vanguard Group’s founder and pioneer of index funds, said Buffett “is a believer” that hedge funds can’t beat the market over time.
“He's been talking about indexing and the S&P 500 since before I ever met him,” said Bogle, whose Vanguard now has an astounding $3 trillion in assets under management. “He has set up a trust for his wife's estate and has directed that 90% of it be invested in a low-cost S&P 500 index fund.”
According to Bogle, one of the things working in Buffett’s favor in the bet is that Seides chose a basket of five funds. With even that little bit of diversification, Seides may have cut down risk, but he also may be missing out on putting all his money into one or two high-flyers.
“A single hedge fund can do just about anything,” said Bogle. “You get five of them, they're going to more or less average out. And hedge funds have not done very well for seven or eight years.”
Bogle adds that making money has only gotten harder for the hedge fund world.
“We have more people come into the hedge fund business and the business gets tougher and tougher,” he said. “They're all smart, they're all able, they're all aggressive, they're all quants – almost all of them – and just competitive. And it makes being a winner all the more difficult.”
Those who pick stocks after being tempted by the explosive growth of stocks like Facebook (FB), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG, GOOGL) – the so-called “FANG” stocks – are in for a tough time, warns Bogle.
“More power to you if you pick them at the very beginning, but I don't know anybody who did,” he said. “To look at them today as if they're going to repeat in the future this fantastic early record that they had is just extremely unwise. The trick is picking the next Google or the next Apple – all of these names that are new to relatively new to investing – and even the next General Motors, which is not so new. That it's just a hard job.”
“Looking back and seeing what funds or stocks did in the past is actually counterproductive,” he cautioned. “There’s a lot of what we call reversion to the mean. The good funds tend to go down to the average and the bad funds and stocks tend to go up to average.”
[Note: Buffett and Seides each placed $320,000 – not $340,000 as originally stated – in zero-coupon bonds for a total of $640,000, at the beginning of the bet.]
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