Buffett's Bet with the Hedge Funds: And the Winner Is …

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Warren Buffett won his hedge fund bet. In 2008 he wagered $1 million that a low-cost S&P 500 index fund would beat a hand-picked portfolio of hedge funds over ten years, once fees, costs and expenses were counted. Protégé Partners LLC took the other side. In May 2017, months before the scheduled end date of December 31, 2017, Protégé co-founder Ted Seides conceded in a Bloomberg op-ed: “for all intents and purposes, the game is over. I lost.”

The contest was a public test of two investing philosophies. Passive investing means buying the whole market cheaply and holding it; active investing means paying professionals to pick, trade and hedge in search of better results. The full story is more interesting than the scoreboard, though, because the hedge funds led for years, Seides offered a serious rebuttal, and the prize money itself outperformed both sides.

The Terms of the Bet

Buffett, who believed hedge funds charged fees their performance could not justify, issued the challenge. Protégé, a firm that built portfolios of hedge funds, accepted. The terms were specific:

• Buffett’s side: Vanguard’s S&P 500 Admiral fund (VFIAX), a share class of an index mutual fund. Morningstar listed its expense ratio at 0.04%.
• Protégé’s side: the average return of five funds of funds. A fund of funds invests in a selection of hedge funds, so investors pay the underlying hedge funds’ fees and then a second layer to the manager who picks them. The five funds were never publicly named, consistent with SEC rules restricting hedge fund marketing.
• Measurement: returns after all fees, costs and expenses over ten calendar years, 2008 through 2017.
• Whose money: Buffett staked his own money, not Berkshire Hathaway’s or its shareholders’.
• Beneficiaries: a Buffett win sent the money to Girls Incorporated of Omaha; a Protégé win would have sent it to Friends of Absolute Return for Kids.
• Referee: the Long Now Foundation in San Francisco, a nonprofit that holds the stakes of long-term wagers and keeps the parties accountable.

The “after fees” condition was the heart of the wager. Buffett was not claiming that hedge fund managers lacked skill. He was claiming that whatever skill they had would not survive the cost of paying for it.

How the Ten Years Played Out

The timing looked terrible for Buffett at first. The bet began on January 1, 2008, and within months the 2008 financial crisis was underway. In 2008 the index fund lost 37.0% while the hedge fund portfolios lost 23.9%, the kind of cushioning hedging is meant to deliver.

That head start mattered. A portfolio that falls 37% needs a gain of roughly 59% just to return to its starting value, while one that falls 23.9% needs about 31%. So even though Buffett’s index fund beat Protégé in every single year from 2009 through 2014, it took until 2012 to pull ahead on a cumulative basis.

In 2015 the hedge funds edged ahead for the year for the first time since 2008, returning 1.7% against the index fund’s 1.4%. Then 2016 settled the question in practical terms: the index fund gained 11.9% and the hedge fund portfolios gained 0.9%. Seides later noted that another downturn could have swung the advantage back toward the hedged portfolios, but none arrived before the deadline.

Through the end of 2016, the index fund had compounded at 7.1% per year, against 2.2% per year for Protégé’s picks. Put in dollar terms on a notional $1 million invested at the start, the index fund had gained about $854,000 and the hedge fund average about $220,000. With one year left and a gap that large, Seides conceded, and the S&P 500 finished the final year ahead.

Why Buffett Said Fees Decided It

Buffett laid out his reasoning in his letter to Berkshire Hathaway shareholders published in February 2017, where he said there was “no doubt” who would win. He described the hedge fund managers in the bet as “honest and intelligent people,” but called the results for their investors “dismal, really dismal.”

His target was the cost structure. The traditional hedge fund fee model is “2 and 20”: a 2% annual management fee on assets plus 20% of profits. Buffett wrote that this arrangement left managers “showered with compensation” while investors often received little more than “esoteric gibberish.” A fund of funds adds its own fee on top, so the end investor pays twice.

A hypothetical example shows the drag. Assume a hedge fund earns 8% gross in a year on a $100,000 investment. A 2% management fee takes $2,000. If the 20% performance fee is charged on the remaining $6,000 gain, it takes another $1,200, leaving $4,800, or 4.8%. Now assume a fund of funds charges an extra 1% of assets on top, about another $1,000, and the investor keeps roughly 3.8%. The same 8% gross return in an index fund charging 0.04% would leave about 7.96%. These numbers are illustrative only; actual fee terms vary by fund. In this example more than half of the gross return goes to the managers, and over ten years that gap compounds.

Buffett extended the argument beyond the bet. He estimated that wealthy investors and institutions had wasted $100 billion or more over the previous decade by declining to settle for low-cost index funds. He also pointed out that the cost was not borne only by the rich: state pension plans had invested with hedge funds, and he warned that “the resulting shortfalls in their assets will for decades have to be made up by local taxpayers.”

Seides’ Rebuttal: Market Risk and Diversification

Seides accepted the core of Buffett’s point. “He is correct that hedge-fund fees are high, and his reasoning is convincing,” he wrote. “Fees matter in investing, no doubt about it.” But he argued that fees were not the main reason he lost.

His first argument was about the market itself. “Fees will always matter,” he wrote, “but market risk sometimes matters more.” The strength of the U.S. stock market rally after the financial crisis, in his view, went beyond what anyone could reasonably have expected in 2008. He even suggested that a rematch over the next ten years would give him better-than-even odds.

His second argument was about benchmarks. Seides pointed out that the MSCI All Country World Index, a measure of global stocks, performed almost exactly in line with the hedge funds over the same period. His conclusion: “It was global diversification that hurt hedge fund returns more than fees.” The hedge funds owned assets well beyond large U.S. companies, and U.S. stocks happened to be the best place to be.

He framed the comparison as unfair from the start, likening it to pitting the Chicago Bulls against the Chicago Bears: “hedge funds and the S&P 500 play different sports.” Still, he had accepted those terms, and he gave Buffett credit for the outcome with another sports line: “Forget the Bulls and Bears; Warren picked the World Series Champion Chicago Cubs!”

The Tortoise and the Hare

Buffett described the contest with Aesop’s fable. The hedge funds and funds of funds were the hares, darting between exotic asset classes and complex derivatives at high fees. Index investors were the tortoises, holding the market through turbulence while it gained value over time.

Protégé had a different definition of success, stated before the bet began: “Hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment.” By that absolute-return standard, the hedge fund portfolios did what they promised. They stayed positive in most years and cushioned the 2008 crash, but earned far less than the stock market over a decade when stocks did very well.

Protégé also argued that “there is a wide gap between the returns of the best hedge funds and the average ones,” and that this gap justifies the fees for investors who can identify the best managers. The bet tested a portfolio of funds of funds, not a single standout manager, so it did not settle that narrower claim.

The Prize Money Beat Both Sides

The stake itself took an unusual path. Each side put in half of an initial $640,000, which was invested in zero-coupon U.S. Treasury bonds structured to reach $1 million at the end of the ten years.

Then the financial crisis pushed interest rates sharply lower, and because bond prices rise when rates fall, the bonds were worth nearly $1 million by 2012, five years early. By mutual agreement, Buffett and Protégé sold the bonds and bought Berkshire Hathaway Class B shares. That swap had a safety net: if the shares fell, the winning charity was still guaranteed $1 million, and if they rose, the charity would receive the surplus.

By mid-February 2015 the pot was worth about $1.4 million, a 119% gain on the original $640,000. That beat both the Vanguard index fund and the hedge fund portfolios, and the shares rose another 19.1% from the end of February 2015 to September 2017. The best-performing investment in the entire contest was a single, actively managed company: Buffett’s own.

What the Bet Proves and What It Doesn’t

On its own terms the result is clear, but the bet has limits. It covered one ten-year window that opened with a crash and then saw an unusually strong U.S. rally. Protégé’s earlier record shows the other side of the cycle: its flagship fund returned 95% net of fees from 2002 through 2007, against 64% for the S&P 500. A second sharp decline before 2017 could have produced a very different story.

What remains is Buffett’s practical lesson for most investors: costs are certain, while outperformance is not.

FAQs

The Bottom Line

The result matters most to investors weighing low-cost index funds against managers who charge high fees for picking, trading and hedging. One ten-year window that opened with a crash and ended in a strong U.S. rally cannot settle every question, and Seides credited global diversification and market risk for much of the gap. Still, the bet supports Buffett's practical lesson: costs are certain, while outperformance is not.