You’ll recall that Warren Buffett, the greatest money-manager in the history of money-managing, made a million dollar charity bet that an index fund would beat any combination of hedge funds over a 10 year period. The bet began in 2007, right before the Great Recession. In that first year, Buffett’s index fund lost 37% while a five fund hedge combination lost less, thus putting hedge funds ahead in the bet while still being down quite a bit. From then on, passive investing with a Vanguard S&P 500 index fund has destroyed the hedge funds. Here’s a table of returns for all the competitors over the past nine years as reported in Buffett’s annual letter to investors.
The Vanguard index fund is up 85% while the combined hedge funds are up 22%. The only way the hedge funds can win this 10 year bet at the end of 2017 is if the stock market drops about 65% and the hedge funds all take short positions.
Actually, the stock market may have to drop more than 65% because hedge funds still would charge management fees of 5% or more (those details are not publicly available). Essentially, the bet is over. The stock market would have to functionally fall to disaster AND all the hedge funds would all have to be all short in the market – any hedge that had a long position would lose money.
Of course, such a strategy might win the bet, but this is not how actively managed funds sell themselves. Because Protege funds have put themselves in this position, the only way they can win is with an Armageddon play, essentially betting that business and investing in America will cease to exist. But, they sell their services in the belief that business and investing in America will continue, just with variations only they can see, predict, and capture. Thus, even if the hedge funds win this bet, they do so by acting against the very skills, values, and beliefs they espouse.
While counting remains, the bet looks very favorable to the stupidest way to invest your money – just put it in a fund designed to emulate the 500 largest US publicly traded companies which stands as a proxy for a “random walk” with US business and leave it alone. Don’t give your money to an Other Guy who is smart and has a plan. The dumb plan will beat the smart plan over 10 years about 4 to 1.
So. Science in the form of this bet says, index investing is the best available means of earning the most money over a long time frame. Of course, you can argue that this is just one case, but you’re missing the persuasion thinking you’re arguing about science. Science has already proven both rationally through math models and empirically through field tests in the mess of life that index investing beats active management (unless you have inside information like John Maynard Keynes).
This bet is nothing but a persuasion play. Buffett is trying to influence you to use indexing as opposed to paying smart guys to lose your money. He is also exposing the persuasion behind the smart guys who actively manage money. They almost never beat the index over the long run – say 30 or 40 years saving for retirement. Worse, the few smart guys who can beat the index are mixed in with hundreds of other smart guys who can’t. No one know how to pick the right one. You face a double problem with active money management. First, almost no one can beat the index over the long run. Second, you cannot pick the few winners at the start of the race.
Buffett also reveals a fun and persuasive backstory on this bet. He narrates how Jeff Bezos at Amazon started a website called LongBets.com that functioned as a market maker. Someone could offer the terms of a bet like this from 2002.
That same year, Craig Mundie of Microsoft asserted that pilotless planes would routinely fly passengers by 2030, while Eric Schmidt of Google argued otherwise. The stakes were $1,000 each.
Buffett watched LongBets.com with some interest when the idea of this passive versus active investing occurred to him. Buffett has been shouting for index investing for many years and he thought a bet would attract more Reception to his argument. So, he put his offer up on LongBets.com.
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?
What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge.
If you don’t see financial Children of the Night laying back in the sound of silence, you understand nothing about persuasion. These active managers know the math behind indexing and the empirical comparison in the mess of life. They know that they cannot beat the index over 10 years. So, they remained silent and in the shadows in the perimeter beyond good and evil. They know that Other Guys like you don’t know about or believe in index investing. The argument is a failure on the face of it. Really, a randomly sampled and math weighted program will beat smart guys with an MBA from Wharton or Harvard? Come on.
Money managers also know that Other Guys need psychological and relational reassurance and support with investment. Other Guys are risking their hard earned money for a distant future bet of security and happiness. Over the course of 30 or 40 years, most Other Guys will get nervous, greedy, or stupid left alone, so they pay a money manager for that psychological reassurance. And, while active managers won’t beat the index, they will still deliver a substantial gain to those Other Guys in 30 or 40 years. And, those money guys will also earn a substantial gain on your money, too, a gain you could have kept if you’d gone with index investing.
See the eternal and compelling dynamic of Falling and Fallen Apples. The science of investing to date cannot be more clear. For most Other Guys, indexing is the clear winner. Yet, human nature demands persuasion plays over that long run of 30 or 40 years as markets inevitably gyrate. It takes enormous courage to believe in theory and research especially when the mess of life gets extremely messy.
Then Buffett details an even more interesting persuasion problem with a different set of Other Guys. For small investors like the overwhelming majority of people, indexing is the best choice. But what about those who are wealthy or who run large endowments, like universities? Read the persuasion analysis of a master.
I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.
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. In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars.
You can only laugh at these Bolivian Banks who have great wealth and all that supposedly accompanies it: wisdom, judgment, intelligence, experience, superiority. They are even more vulnerable to persuasion than the little Other Guys in Buffett’s analysis. We detailed this with university endowment funds from Picketty’s work, remember?
Close with obvious lessons. First, science says use index funds for long term investing no matter who you are (unless you have inside information and are willing to risk prison and fines if caught). Second, persuasion says, Children of the Night will continue to panther their less effective service because of human nature and persuasion. And, third, Warren Buffett is not only the greatest money-manager of all time, but a world-class persuasion maven.
P.S. So. How does Warren Buffett beat the index? He doesn’t manage stocks and bonds. He buys and sells businesses. This truly is an apples and sledgehammers distinction. Hedge funds and actively managed funds typically restrict their activity to stock and bonds. Buffett, in contrast, buys the company, sometimes large chunks, sometime the business entire. Then he makes sure the business runs right. For example, Buffett is big on owning insurance companies. He owns Geico as a subsidiary of his primary business, Berkshire Hathaway. But, he doesn’t own Geico stock. Buffett gets to all of Geico’s income and wealth first then decides whether to offer dividends on the stock, how much debt to acquire, and on and on with factors that determine a stock’s value. Hedge funds and actively managed funds cannot operate like this.
If you are great at business – and Buffett is truly one of the greatest business managers in the history of the world – then use your money like Buffett: Buy a good company and make it better. Barring that, buy shares in Berkshire Hathaway which closely mirrors Buffett’s business success. Mr. Buffett still plays a major role in the company, but he is getting older and will likely cease that major role. Whether his successors have the same touch is essentially the question you have to ask yourself when you put your money in an actively managed fund. Is that person as good as Warren Buffett and one of the few who will beat the index over 30 years or is that person just some Other Guy?
Why not just buy and hold an S&P index fund?