3 Lessons From Warren Buffett's Bet Against Hedge Funds

Light the Cigar Warren Buffett will almost certainly win his 2007 wager with investment manager Protégé Partners that, for the ensuing decade, the S&P 500 would outdo a pool of five hedge fund of funds. The funds raced to a huge early lead, courtesy of the 2008 stock market crash, which dropped the index 37%. The hedge funds lost only half as much, for the simple reason that they were ... hedged. (Sometimes with investment research, the blindingly obvious suffices.)

For that same reason, the funds trailed the index badly during the ensuing stock market rally. Because that rally was longer and larger than the downturn, the competitive position reversed, with the index moving well in front. The index has now gained 71% since the bet took effect, with the funds at 25%.

That gap is too large for a repeat of 2008 to reverse the outcome. For the hedge funds to win the bet, either the stock market must plunge even further over the next 16 months than it did in '08 (shudder), or it must fall equally far, while the funds dodge the losses almost entirely. Neither scenario is likely.

Lesson #1: Costs Matter Buffett bet against costs. He believed that although some funds, in some years, could overcome the gravity of their expense drag, over time they inevitably would be pulled down. Buffett's reasoning was the same that has been used by Jack Bogle to support index investing. Clearly, mutual fund investors fully understand that argument, as witnessed by the sales figures for index funds--and by Vanguard's enormous size.

Buffett's case was even stronger than Bogle's. Whereas the average U.S. stock mutual fund charges 150 basis points more per year than the cheapest of the index funds, with the best active funds mostly being under 1.00%, hedge fund costs are considerably higher. What's more, as Roger Lowenstein points out, Protégé's choices carried a second layer of fees. Being funds of funds, they bore not only the costs of the underlying funds, but also the fees levied by the funds-of-funds managers.

In total, those charges summed to just over 3.00% per year. (That figure would be higher had the funds' results been better, because of steeper performance fees.) It would have taken a minor miracle for the funds to clear that hurdle. Such a feat would have required not only collectively excellent portfolio management, but also favorable tailwinds from the financial markets. In short, the funds had to be lucky.

Lesson #2: Time Periods Matter The funds, in fact, were not lucky. Last year, Protégé's Ted Seides discussed the various headwinds. For this contest--meaning winning the relative contest with the S&P 500, as opposed to posting the highest absolute returns--the funds preferred a weak stock market. They got one that was pretty good. The funds wanted their foreign stocks to outgain the U.S.-based S&P 500. That did not happen. The funds hoped for high interest rates on cash, which they held and the index did not. No again.

All those things were true; the funds were not fortunate in their timing. Had the wager been made a decade earlier, Mr. Buffett would probably have lost. The 1998-2007 time period contained several factors that would have worked in the funds' favor. In particular was the collapse of giant U.S. technology stocks. If there is one thing at which hedge funds excel, it is in avoiding highly publicized, highly priced investments that indexes, by virtue of their construction, must own. Most hedge funds shone during the 2000-02 technology sell-off.

Then again, there was a reason that this bet was made in 2007, not 1997. The wager occurred after hedge funds had made their mark. In 1997, they were little-known and little followed. A decade later, thanks in large part to their 2000-02 heroics, they were front-page news and were taking in tens of billions of new dollars each month. Hedge funds had become large and famous enough to be worth Buffett's while--thanks to good fortune that was unlikely to continue.

Lesson #3: Taxes Matter Nobody much talks about this point, because the Buffett-Protégé wager is based on pretax results. In that it resembles nearly all performance measures, including SEC-mandated computations of mutual fund total returns, Morningstar's star ratings, and the peer-group rankings of investment managers that are published by institutional consultants. Also, because it appears that Buffett will prevail by a comfortable margin, there has been no need to strengthen his defense. He will be a winner under the current terms.

But … it's worth pointing out that for many hedge fund owners, the real-life results have been even worse than indicated by this theoretical contest. Although institutional buyers tend to hold hedge funds in tax-sheltered accounts, as endowments or pensions, individual investors must often use taxable assets. (Mitt Romney aside, it's tough to grow a multimillion IRA.) Few successful hedge funds are as tax-efficient as the leading index funds.

Indeed, writes an NYU adjunct professor, "Many popular strategies throw off income taxed at the highest rate. Worse yet, many investors in funds of funds and 'investor' hedge funds find themselves paying tax on more profit than they have actually made." In the latter situation, the hedge fund collects its management fee; the fund of fund collects its management fee; and the government gets its cut. All three are paid by the only entity that has put in the money--the fund shareholder.

"Worse yet" is an understatement!

Trust, but Verify It's tempting when encountering investment debates to side with authority. As well as Protégé Partners has fared through its history, it can't match Buffett's achievements. Thus, one's first instinct upon hearing about this wager would be to take Buffett's side by expecting victory from the S&P 500.

But that would be a short cut, and potentially costly. Indeed, Buffett was right. But so had been 2008 hero John Paulson, before he encountered gold. So had been Bill Gross, for more than two decades in his publicly tracked mutual fund, and even longer with his privately managed accounts. So had been Legg Mason's Bill Miller, in beating the S&P 500 for 15 straight years. All three earned large fortunes by making successful investment decisions. Eventually, all three made prominent investment mistakes.

The better reason for lining up with Buffett would have been to work through the logic. The funds' cost disadvantage was huge. They had overcome their handicap during the previous decade by benefiting from the perfect storm--but such a storm was unlikely help them over the next 10 years. And the tax consequences, while not officially part of the discussion, were dire for those who held taxable accounts.

Buffett, check. Logic, check. While there are no guarantees with investing, those make for two fine starting points.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.