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Buffett Brings Out the Victory Cigar

One year early, he celebrates winning his bet against hedge funds of funds.

John Rekenthaler, 02/28/2017

Game Over 
This weekend, Warren Buffett declared victory on his 2007 bet that Vanguard 500 Index Fund VFIAX would beat a pool of hedge funds over the ensuing decade. The wager has one year remaining, but given that the index fund has gained a cumulative 85% for nine years, while the five challengers have averaged 22%, Buffett will likely retain his statuette.

As Buffett writes, the stock market generously provided the contestants with a fair test. Had stocks been unusually poor over the time period, hedge funds (which do indeed hedge, although not as much as their name suggests) would have held an advantage. The reverse would have been true in a roaring bull market. Instead, stocks landed in the middle, with the index fund appreciating by annualized 7.1%. A Goldilocks' result for the trail, if not for investors.

It's impossible to know what went wrong for the actively managed contestants. The names of the challengers have not been publicly released. Even if they had been, the names of their holdings--in this case other hedge funds, as the five contestants are each hedge funds of funds (HFOFs)--would be unavailable. And if those positions were somehow obtained, their underlying portfolios would be unavailable. One time, two times, three times opaque.

By the Numbers
So much, therefore, for any attempt at performance attribution. We can't know what went wrong with the HFOFs. From Buffett's perspective, however, such work is unnecessary. What matters is the underlying math of the funds' expense structures:

"The underlying hedge fund managers in our bet received payments from their limited partners that likely averaged a bit under the prevailing hedge fund standard of '2 and 20,' meaning a 2% annual fixed fee, payable even when losses are huge, and 20% of profits. ... Still, we're not through with fees. Remember, there were the fund-of-funds managers to be fed as well. These managers received an additional fixed amount that was usually set at 1% of assets."

From there, the logic is straightforward.

It is true that some managers possess superior skill. Buffett states that during his lifetime, he has pegged 10 winning managers "early on" in their careers. Further, he states, he has met only a small percentage of investment managers. "There are no doubt many hundreds of people--perhaps thousands--whom I have never met and whose abilities would equal those of the people I've identified."

That would seem to be great news! Hundreds or even thousands of active investment managers who can beat a relevant index, and who can be known before the fact.

is vice president of research for Morningstar.

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