Warren Buffett: Why Index Funds Trump Hedge Funds

You’re probably tired of hearing this, but long horizons and low fees are two of an investor’s best friends. Sure, everyone wants to get rich quick, but the best route for most of us is to diversify our holdings, control costs and be patient – which is exactly why index funds are becoming more popular by the year.

Just ask Warren Buffett.

The world’s greatest value investor and chief of Berkshire Hathaway (BRK.B) once again proved the superiority of keeping things simple and cheap vs. complicated and costly when he won a 10-year bet with some folks in the hedge-fund industry at 2017’s end. To recap: In 2007, Buffett made a $1 million wager that a Standard & Poor’s 500-stock index fund would outperform a group of hedge funds over the next decade. If he won, the payout would go to charity.

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So how did the Oracle of Omaha do against Wall Street’s Masters of the Universe?

He smoked them.

Index Funds Were Better, Cheaper

From the start of the bet in 2007 through the end of 2016, a basket of hedge funds selected by Protégé Partners – the hedge-fund managers with whom Buffett made the bet – returned 2.2% compounded annually. Buffett’s S&P 500 index fund, however, returned 7.1% compounded annually.

Although the final performance numbers won't be available until later this year, the point remains: It's truly extraordinary how much the wealthy investors in these hedge funds paid for so much underperformance.

For the uninitiated, hedge funds are sophisticated investment vehicles generally open only to accredited investors – people with a net worth of at least $1 million, excluding the value of a primary residence, or earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, according to the Securities and Exchange Commission. In other words, these are people of some means.

Hedge funds promise such folks outsize returns through good times and bad. They claim to be staffed by the best and the brightest stock-pickers backed by teams of brilliant research analysts employing the most sophisticated algorithms money can buy.

Naturally, such bespoke service doesn’t come cheap. At the time Buffett made his bet, the typical hedge fund charged a fee of 2% of assets under management and 20% of profits after certain performance thresholds had been met. How whopping are those fees? Get ready for a spit take. The average mutual fund charges about 0.6% of assets under management with no additional performance threshold fees, according to Morningstar.

Buffett has long been a critic of excessive fees, notes David Kass, a professor at the University of Maryland’s Robert H. Smith School of Business who studies Buffett and is a Berkshire shareholder.

“Buffett said at a recent Berkshire annual meeting, when he asked a hedge fund manager why he charges '2 and 20,' the response was 'because I cannot get 3 and 30,'" Kass says.

Indeed, the passively managed Vanguard 500 Index Fund Admiral Shares (VFIAX), which is what Buffett bet on in his wager with the hedge fund machers, charges investors just 0.04%.

Even if you don’t have $10,000 for a minimum investment, the Vanguard S&P 500 ETF (VOO) charges the same 0.04%, and the Vanguard 500 Index Fund Investor Shares (VFINX) charges a still-meager 0.14%.

“Warren Buffett has recommended that when he is no longer here, his wife should invest 90% of her money in a low-cost S&P 500 index fund such as that offered by Vanguard. The other 10% would be invested in Treasuries to provide liquidity,” Kass says.

Fees were hardly the only factor in the wide performance discrepancy.

Recall that the stock market crashed 50% at one point during the timeframe of the wager. The hedge-fund guys had perhaps a once-in-a-lifetime opportunity to buy assets on the cheap and deliver ballistic returns. Yet they failed to even keep pace with the broader market.

“In order for hedge funds to justify their ‘2 and 20’ fee structures, their rates of return after fees must exceed what any investor can earn from a low-cost S&P 500 index fund,” Kass says. “Their fee structures makes this extremely difficult to achieve over time.”

Buffett made the bet as a way to highlight the hedge fund industry’s ridiculous fee structure, but the lessons extend all the way down to even the cheapest actively managed mutual funds. Investors need to keep a sharp eye on costs and returns.

It’s far too easy to overpay for underperformance, even when you’re rich.