Buffett on Pace to Win Hedge Fund Wager

With only four years to go left on the tenure wager between a hedge fund based out of New York and Warren Buffett, it seems quite clear that Buffett will when the bet easily.

Does this have to do with the billionaire investors investing magic? Absolutely not. Anybody could take Warren Buffett’s side of the bet. By SPX, the Standard & Poor’s 500 index beginning in January 2008 through a low-cost index fund and then wait 10 years. The hedge fund was capable of doing whatever it wanted as part of the bet and we presume that it owns a collection of numerous hedge funds.

Initially the bet was for $320,000 worth of bonds that would mature to $1 million in the decade’s time, with all gains going to charity. Please note that Warren Buffett put up his own money.

In the beginning of 2014, MorningStar reported that the approach by hedge funds earned, after fees, 12.5%. During the same time, Warren Buffett’s index fund approach gained 43.8% in value. A major part of the difference in strategies comes down to the amount of fees being paid. Buffett purchased an index fund that only charges 0.05% as an expense ratio. The hedge fund, on the other hand, typically costs as low as 2% and as much as 20% in profits.

Record Closings

In more worldly terms, if using the index approach for a retirement portfolio containing $100,000, it would cost roughly $50 per year to maintain. The hedge fund strategy, on the other hand, would cost $2000 per year plus 1/5 of the potential upside gain, which is taken out of the account each quarter.

Let’s say that the market returned 10% per year. The hedge fund manager would soon take $4000 in fees. Rather than making $110,000, the portfolio would only be worth $106,000. If the market returned a -2%, the hedge fund would still take its 2% in fees, which amounts to $1960 per year, and the investor would only have $96,040 left in their retirement account.

How are they doing specifically? It’s very difficult to tell, but the hedge fund numbers are appearing and they do not look very attractive. Many of the hedge funds bet heavily on commodities, which we know have tanked recently. So far this year, the average hedge fund has only returned about 2%, according to Bloomberg news information. And not only that, we are on pace to see another year of record hedge fund closings.

During the first half of 2014, Bloomberg news reported that 461 hedge funds closed their doors forever. 2009 was the worst year for hedge fund closings. During that time, 1023 hedge funds permanently shut down when the market tanked and reached rock bottom.

If hedge funds followed the index fund strategy – Warren Buffett’s strategy – instead of closing their doors they would’ve had the opportunity to recoup their gains as the market came back over the next few years. They should not and would not have needed to find a different strategy – i.e. shorting, commodities, wild frontier market bets – in order to turn it around. The Vanguard 500 Index Admiral Class, ticker symbol VFIAX, purchase by Warren Buffett has returned 13.16% year to date, and over the past five years it has posted a return of 15.49% annually.

Everything You Need to Know

There is not a lot of research required in order to purchase and hold an index fund. As a matter of fact, zero research is required. You have no need to understand what happened to the economy today, tomorrow or 10 years in the future. You need not know what board plans to fire what CEO. And you have no need to try and figure out which companies are going to see massive success and which companies are going to fold and fail.

The only thing that you really need to understand is that when you plan to retire, you should hold the correct level of stocks versus bonds while judiciously rebalancing.

This is the precise reason that Warren Buffett is winning this bet. There’s no question that he does some tricky private equity things in his own firm with his investors money at Berkshire Hathaway. He does plenty of research when buying businesses for shareholders as well. But this has nothing to do with the index fund approach.

That’s Warren Buffett’s burden to carry as he oversees billions upon billions of dollars of other people’s money, and it’s perfectly fine. But as Buffett will tell you and as he has said many times before, he feels that his own heirs should put their money into index funds and wait patiently. Retirement investors of a prudent nature should also do the same because it’s the wise choice.

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