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Warren Buffett is embarrassing the hedge fund business with his historic wager

Legendary investor Warren Buffett is crushing the hedge fund industry in his bet against their profession and their massive fees.

Buffett has been a critic of the hedge fund industry. Hedge funds are known to charge investors fees known as “2-and-20”, meaning 2% of assets and 20% of profits. Those fees can vary with some being lower and others being as high as 3% and 30%.

Buffett argues that investors, both small and large, would be better off putting money in low-cost index funds, like those offered by Jack Bogle’s Vanguard.

Buffett’s $500,000 wager

In Berkshire’s 2005 shareholder letter, Buffett argued that active management professionals (hedge funds), as a group, would underperform the returns achieved “by rank amateurs who simply sat still.” Buffett’s thought was that the active managers who collect massive fees would leave their clients “worse off” than the amateurs who simply invested in unmanaged low-cost index funds.

At that time, Buffett offered to wager $500,000 (for charity) that no investment professional could select a set of at least five hedge fund that would match the performance of an unmanaged S&P 500 index fund. The bet was to last ten years and Buffett picked a low-cost Vanguard S&P fund as his contender.

Warren Buffett answers students questions at Columbia University on Friday, January 27.

“I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?” Buffett wrote in his newly-released shareholder letter. “What followed was the sound of silence.”

Only one person took the “Oracle of Omaha” on. That was Ted Seides, the co-manager of Protégé Partners, a funds-of-funds that allocate to hedge funds. For his part in the bet, Seides picked five funds-of-funds to go up against Buffett’s Vanguard S&P index fund.

“The five [Seides] selected had their money in more than 100 hedge funds, which meant that the overall performance of the fund-of-funds would not be distorted by the good or poor results of a single manager,” Buffett wrote in the letter, adding,  “Each fund-of-funds, of course, operated with a layer of fees that sat above the fees charged by the hedge funds in which it had invested. In this doubling-up arrangement, the larger fees were levied by the underlying hedge funds; each of the fund-of-funds imposed an additional fee for its presumed skills in selecting hedge-fund managers.”

While there’s still one more year to go, Buffett’s index fund pick has smoked the hedge fund industry. He notes than $1 million invested in the fund-of-funds would have only gained $220,000, while the index fund would have gained $854,000.

Buffett adds that the underlying hedge funds the fund-of-funds invested in have “a huge financial incentive” to perform as do the fund-of-funds who chose those managers.

“I’m certain in almost all cases the managers at both levels were honest and intelligent people. But the results for their investors were dismal — really dismal. And, alas, the huge fixed fees charged by all of the funds and funds-of-funds involved fees that were totally unwarranted by performance were such that their managers were showered with compensation over the nine years that have passed. As Gordon Gekko might have put it: ‘Fees never sleep.'”

Yahoo Finance will host the exclusive live stream of Berkshire Hathaway’s shareholders’ meeting on May 6, 2017.

Julia La Roche is a finance reporter at Yahoo Finance. Follow her on Twitter.

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