Warren Buffett: I Bet on Index Funds—So Should You

Filed in Money by on April 24, 2014 11 Comments

Warren Buffett - Index fundsWarren Buffett is so thoroughly convinced that high-cost actively managed mutual funds cannot consistently beat low-cost index funds that he bet $1 million on it! Now that’s putting your money where your mouth is.

Buffett knows that over the long term actively managed mutual funds rarely justify their high fees with market outperformance. As a result, investors in these funds are made less wealthy, while the fund managers line their own pockets. Buffett is a harsh critic of these investments. Despite his incredible personal wealth, he often champions the cause of small investors.

So in 2008, Buffett placed a very public wager with Protégé Partners, a prestigious New York-based hedge fund manager. He bet that his simple choice of Vanguard’s 500 Index Fund (which tracks the S&P 500 index of large company stocks) would outperform Protégé Partners’ hedge funds over a 10 year time frame, net of expenses.

Well, six years in, the hedge funds are getting trounced. Buffett’s Vanguard 500 Index Fund has earned a net 44%, while Protégé Partners’ hedge funds have eked out only a measly 12%. Protégé Partners’ CEO was recently quoted as saying, “We’ve got our work cut out for us.”

I’m not sure if that will qualify as the understatement of the year, but it’s definitely in the running!

You might be surprised, even shocked, to learn that for their often mediocre or worse performance, hedge funds employ a very expensive fee structure called “2 and 20.” What this means is that they charge 2% of your invested balance every year regardless of performance, and on top of that another 20% of any profits your investments earn. So if you earned, say, 6% in a given year, they would take roughly half of that away from you in fees, leaving you with a measly 3%.

To make matters worse (and even more outrageous), if there is a year in which they lose money, they do not give back any of the 20% fee they earned on earlier profits. So if your investments earned $10,000 one year and lost $10,000 the next, along with charging you their fixed 2% of invested capital both years, they would collect 20% of the profits in Year 1 ($2,000) and pay none of that back to you in Year 2 when they lost it all back! Your investments earned a net profit of zilch over the two year time frame, and yet they collected $2,000 in fees on the “profits!” Huh?

Oh, and by the way, had you instead invested in a low-cost index fund, they charge only about .1% per year on your invested balance, and nothing for the profits earned. So if your investments in this fund earned 6% in a given year, you would get to keep 5.9%.

You might ask why anyone would invest in hedge funds. Well, a very few hedge funds do quite well, not necessarily because they are smarter than everyone else, but probably often due to the law of large numbers. If enough people engage in any given activity, such as playing slot machines, some will have unusually favorable results just because so many people are participating. I’ll admit that a very small number of hedge fund managers may actually have superior stock picking expertise, but then the problem is that these funds are usually only available to extremely wealthy and well-connected investors.

Most hedge funds have average to weak performance, and they charge you an “arm and a leg” for it.

So if any of you plan to invest in a hedge fund, can you do me a favor? Rather than doing so, please instead give me a call. I’ve got some swampland in Florida I’d like to sell you at a low, low price, just for you, because you are so special!

About the Author ()

TIM MCINTYRE retired in 2004 from his position as president of Applied Systems after facilitating a successful sale of the company. At only forty-six years old, he made the unusual decision to fully retire to pursue other interests and simply enjoy free time. As a hard-driving Type A personality, this turned out to be a significant challenge for the Notre Dame and University of Chicago-educated MBA, CPA, and Certified Cash Manager.

Comments (11)

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  1. robert sizemore says:

    Thats why I go to you for investment advise! I have learned so much from you. Thank you.

  2. Amy says:

    I’m concerned the market is on the high end and ready for a correction, so do I want to invest in index funds if it is?

    • Tim McIntyre says:

      Hi Amy. Thanks for the question! Index funds are a low cost way to invest in a variety of investment instruments. There are stock-based index funds, as well as bond-based index funds and other safer investments. If you are specifically concerned about the stock market being overvalued, you can sell some of your stock investments (whether they are in individual stocks, actively managed stock mutual funds, or index funds). The better way to protect yourself against too much stock exposure is to maintain a portfolio of stocks, bonds, and money market investments that you can live with in good times and bad for the stock market. If you have any more questions, by all means, give me a call. Take care, Tim

  3. Lisa Fox says:

    Very interesting read. Thanks for sharing that perspective!

  4. Ryan Quinlivan says:

    Being that you were able to retire at age 46, did park your money strictly in index funds?

    • Tim McIntyre says:

      Great question. I discuss this in one of my “Living” articles titled “Goals Are Completely Useless Without This,” so you might also read this post. I had a pretty strict saving and investing plan that I was following, which I projected would allow me to retire comfortably at age 52. I ran the numbers and determined I would have $1.2 million saved by that age, and I was on track to achieve that goal. And yes, I was fully invested in stock and bond index funds, with a tilt toward small cap and value index funds, which provide extra return (more on this in a subsequent post). I was able to retire even earlier, at 46, when the fortuitous event of the sale of the company I was President of occurred. The key to retiring early for most people is starting to save as early as possible in their working career, and using low cost index funds, the power of the stock market, and compounding of returns over time to build wealth.

      • Ryan Quinlivan says:

        My first response to the original post was that it was an atrocious comparison, but I’ll dial it back. On the whole, your point that investing in index funds is more effective than mutual funds is correct, but it needs some qualification. In a highly liquid & highly efficient market like large-cap U.S. equities, yes mutual funds rarely outperform index funds net of expenses. However in less-efficient, less-liquid markets such as emerging markets, hedge funds, venture capital, private equity, it does pay off to pay for active management.

        A few points:

        A 44% gain over 6 years is only a 6.3% gain annually, not great for a five-year bull market that returned 26% in the S&P500 last year alone…

        While it is true that if a hedge fund loses money in a year they “Do not return any of the 20% fee they earned on earlier profits,” it’s absurd to presume there would be some sort of investor clawback on earlier profits. Moreover, if they do incur a loss, they don’t make a take a profit until they make the money back—which is often how hedge funds go bust. There is some survivor-ship bias in measuring 10 year performance of hedge funds.

        Your point that it’s difficult for funds to beat the market every year is accurate. While some do develop a “hot-hand” there is greater evidence of persistent poor stock picking than good stock picking among managers. A 2008 study of the top-20 performing UK equity mutual funds, only 12 had positive alphas not attributed to luck. The rest of the funds’ positive alphas were attributed to luck; surely hard to repeat. The argument for hedge funds is you don’t have to be right all the time, just some of the time; one big play a year. You have to pay for the liquidity that index and mutual funds offer in that you can get your investment back anytime you like, whereas investing in a hedge fund typically you can’t  get out of your position for 3-5-10yrs. 

        In the end, it’s not an apples to apples comparison between hedge funds and index funds. A much more fair comparison would be index funds vs actively-managed mutual funds investing in the same class of equities. There’s a reason hedge funds are only open to institutional and accredited investors. Hedge funds also allow pursuit of more exotic investment strategies, enabling you to make money no matter which way the market goes. So when grandma loses 40% of her retirement account in 2008, hedge funds still make money. 

        For your neighbor Joe across the street, it’s probably better that Joe invests in an index fund rather than Joe picking stocks himself. But it’s rather imprecise to say that across the board index funds are the best investment vehicle.

        I could be wrong though.

        • Tim McIntyre says:

          Ryan! You make a lot of good points. Also, though, I have to disagree with some. What else would you expect from a Type A like me!

          First, I think the comparison of index funds to hedge funds is fair. Hedge funds are a type of actively managed fund. I agree that the “fairest” comparison would be of an index fund to the same class of actively managed fund, like an S&P 500 index fund to a large cap-based actively managed fund, but I don’t think that is entirely necessary or the central point Buffet is trying to make. It is the low cost, highly diversified nature of index funds that he is focusing on, and again, I think the test is fair enough. Plus I rarely disagree with “The Master!”

          I didn’t bring this point out in my post, because it is a bit technical, but the biggest problem with the hedge funds’ 20% fee on profits is not the lack of a clawback, but rather that it encourages volatility. All other things equal, they earn higher fees if their investment returns are up one year and down the next. Since most investors equate volatility in returns with risk, this is a structure which encourages just the wrong sort of behavior on their part.

          Lastly, I don’t agree that active management is superior to indexing in less efficient markets like emerging market stocks and bonds. The increased bid-ask spread and the lack of liquidity in these markets causes active management to have even greater hurdles to overcome, and many studies have shown that active management fares as poorly in these market as I does in more efficient and liquid markets like those found in the US. Oh, and the comparison between indexing and alternative investments such as venture capital and private equity is actually a bit unfair, since those latter types of investments involve being active in the management and operation of businesses, which is entirely unlike owning a mutual fund. These investors are actually running the business, not just picking stocks.

          You are obviously very bright and educated, and I appreciate your feedback. I hope my followers got some benefit from the discussion of our opinions!

  5. Ryan Quinlivan says:

    Hey I appreciate the discussion! Thanks Tim.

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