My judgement of this bet would depend entirely on the basket of hedge funds in question. Lets assume that the hedge funds in question only invest in US equities. If the aggregate assets under management make up a significant fraction (exactly what that value would be I'm not sure, but I bet Buffett could figure it out) of the value of the market, then they couldn't beat the market in aggregate, and the fees would make Buffett win.

On the other hand, if these are smaller funds, and if they have access to a broader range of investments then US equities (which is highly likely), really anything goes.

I believe that the Protege argument is quite valid. You are not comparing a market index with a stock picker who is attempting to outperform the market. With hedge funds you get much lower volatility with greater consistency in returns. How has the S&P performed over the past 10 years? History is all well and good, but the domestic economy is a changing animal and the opportunity to invest internationally, hedge bets with derivatives, and provide returns in times of trouble due to varied investment opportunities allow the hedge fund world to thrive. "past performance is not indicative of future results"...

You can see more background on this bet in the Fortune article by Carol Loomis:
http://money.cnn.com/2008/06/04/news/newsmakers/buffett_bet.fortune/index.htm

While I agree with Buffett that hedge funds don't usually do better than passive investment, the fact that these fund of funds can invest in broader markets beyond SP500 will provide them with an advantage.

If the fund of funds were limited to investing only in US large caps, then the odds would be more in Buffett's favor.

Even if protege is right, Buffett is almost always right, so for the fun of it, i'm voting for Buffett. Good luck!

Buffett's going to win. If you would like to know why read "The Little Book of Common Sense Investing" by John Boogle.

The problem I see with the hedge fund argument is that it's really difficult to decide to invest in a losing position (and to justify it to one's shareholders/owners). However, whether one has a short or long position, at least some choices will be made on the way up or the way down -- times when it would seem ill-advised to take such positions. Even if one were supremely informed and intelligent, market forces in managed funds favor fund managers with relatively short-term positive performance, which can endanger long-term positive performance.

Assuming that all returns exclusive of capital appreciation (dividends and other distributions) are reinvested in the S&P 500 fund automatically, whereas the "fund of funds" actively manages these returns, by virtue of dollar cost averaging the S&P 500 fund will have an advantage.

it will likely be a bear market for equities for a good portion of the next ten years, so FoHFs stand a chance to outperform the S&P, simply because they will be short certain stocks (e.g. financials)

Am quite a novice when it comes to hedge funds and such, but I would never vote against one Warren Buffett. Time will tell.

Betting against Buffett is highly ill-advised. But this long bet is not about Buffett or even betting against him. It is FoHF (carefully selected portfolio) vs S&P500 and as pointed out by others, it is probably a case of oranges vs apples. Smart active managers vs an index (that at best represents the average investor). Can smart active managers outperform the index by a margin that exceeds costs/expenses? Buffett may be philosophically opposed to the idea of hedge funds and their dubious value creating contribution, but in the huge hedge fund universe, surely there must be some good smart fund managers? If Protege (smart and experienced?) picks the wheat from the chaff - managers who actively develop and execute good strategies - they can achieve home-runs, whether the S&P 500 goes through thick or thin. Because of this asymmetry, I vote for the intelligent investor (Protege?) instead of the average investor (not Buffett).

The hedge fund argument that:

"Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue."

is the one I find suspect. The class of "top hedge fund managers" is one that changes over time, and I suspect membership in the category is due more to luck than to skill. Long-Term Capital Management was run by smart guys, but their calculations of risk were faulty.

... Buffett dies before 10 years elapse? What are the terms for that scenario? Does the charity still acquire the money???

I am siding with the challenger simply because I am aware of the history. There are currently hedge funds out there that have outperformed the S&P over a ten year consecutive span, net of fees.

With that in mind, assuming the challengers have a good hand in picking and switching funds when needed, they will have no problem winning this bet.

Given limited information, I respectfully disagree with my teacher Warren Buffett.

S&P 500 would deliver returns in the region of 8-10% compared to returns of around 12-15% by a portfolio of top hedge funds.

According to CNN Money.
It's between Buffett (not Berkshire) and Protégé (the firm, not its funds). And there's serious money at stake. Each side put up roughly $320,000. The total funds of about $640,000 were used to buy a zero-coupon Treasury bond that will be worth $1 million at the bet's conclusion.

Simply today's $640000 value more than $1million after 10 Year. Can't these money go to Girls Inc. of Omaha now to get better value on $s.

Within 10Year + to S&P is dividends; splits and more. (with over 20year history has gone thru couple of ressesion)
Within 10Year - to Hedge is FEES atleast 1.5% each quarter on fund.(Pre-Mature - not sure has gone thru any ressesion)

Yes, it's very interesting to see what happens...
Good luck, and see you in 10 years (I hope!)

-Steven Burda

www.linkedin.com/in/burda

I have no strong opinion about the bet, but I am grateful for the boost that Mr. Buffet and Protege have given to the stature and visibility of longbets.org. I notice several bets (including my own #197) have picked up a lot of votes and comments since the bet was made. I was afraid the longbets site was fading into obscurity.

I'm siding with Protege. While Warren is likely correct for most investors, I believe Protege's principals have the demonstrated skills to be one of the few who will do better than the S&P500.

F.L. Baker III

If you assume that the S&P stays negative for this year, returns nominally next year, then averages 10-12% like it has historically until the end of the 10 years, when there will probably be a boom (maybe the rumored 2nd tech boom), then on these very rudimentary assumptions, the annualized return that these FoFs would have to outperform may be around 17%. (Note that between 1990 and 2000, where there was at least one boom and bust, the S&P returned about 14% annually). So its doable, but tough. like someone else said, it really depends on the funds picked. Technically they have an advantage, but they are up against Warren Buffett...now if George Soros was on the other end, now that may be something different.

I'm full of admiration for all of the above intelligent, knowledgeable comments--but my two cent's worth goes loyally to WB, in hopes that he will be able to personally turn over the funds in ten years, with a good Nebraska quip.
Beverly Crandall

Warren's common sense and track record speak for themselves.

Fund of funds - so many layers of fees ...

I am a great admirer of Warren and Charlie and biased but the odds are - I think again - in favour of the Oracle.

Very ironic that Mr. Buffett would take a truism, that the average active investor lags the market, and take a bet against specific investors. Mr. Buffet not only has demonstrated that it can be done, and claimed that he (if he was running a smaller fund) could do it by a large margin, but he runs a hedge fund himself. Berkshire is in essence a large publicly traded hedge fund. The original Buffett Partnership was a hedge fund.

With my eyes closed.

Buffet was wise to make it a bet on fund of funds rather than just a basket of hedge funds. Not only does the bet contain an extra layer of fees and an extra layer of active investing (picking the best stock pickers), but also it forces real world capacity and liquidity constraints. Specifically, not every hedge fund is open for investment, and those that are have lock up periods limiting liquidity and gating provisions limiting redemptions. One can certainly pick five funds today that would beat the S&P over ten years net of fees - problem is, those funds are closed to new investors. In addition, as institutional investors become smarter about illiquid hedge fund investments, the return profiles will change drastically.

However, the Protege team were wise to extend the bet to 10 years. Why? Because within the next decade, hedge funds and fund of funds fees will come down due to competition for assets for smaller funds, more funds going public, educated institutional investors going "fee" shopping, mutual funds being allowed to short more, and the gradual retail-ization of hedge funds allowing them to be marketed (and compete) more openly. The de rigeur management and performance fees of today will be a distant memory (though they will still exist). I'll even predict that many fund of funds will go to a flat performance fee and no management fee within five years. Hence, even if Buffet is right on the performance prediction today, the promise of future fee reductions alone may undo his wisdom.

I'm excited to see what happens.

First, just wanted to comment on Lance Paddock...the difference between Buffett and the others (assuming they are as good) is the fees! It is instructive to compare the Buffett partnership fee structure & Buffett's current salary with current trends in hedge fund management fees.

Other differences come up, i.e. it was a lot easier for Buffett in an era of pen & paper, inefficient markets, less talent devoted to the business (lots of high IQ people were into science and engineering then, as opposed to creating algorithmic approaches to making money on the market today), etc. But the fee difference is enough to make my point. The fund may perform like hell, but the smart hedge fund managers will enjoy the benefits (by definition, they are smarter than their investors), not the investors.

From Protege's perspective, they stand to gain substantially from the bet, even if they lose it. By taking a bet against Buffett, they have pulled off a major marketing coup. They will probably be laughing in ten years from all the extra fees they will have collected from the additional publicity.

I think Buffett will win the bet, but it won't matter to Protege because they will have bought their yatches!

I think Buffett's real charitable contribution here is that he's found a great way of telling everyone to use an index fund. That's great advice. Note that even Buffett gives Protege a 40% chance of winning. That's because they will have picked specific funds and there is great variance in individual funds. If there were a trustworthy source that aggregated all the hedge fund and fund of funds data, then the 500 index would probably have much higher odds of winning than 60%.

Does anybody know if this bet will be measured pre-tax or post-tax? This will change the odds dramatically. (After-tax favoring Buffett; Pre-tax would favor Protege...)

If Buffett is correct - nobody really benefits (except for Buffett's own vindication). If Hedge Funds are correct - a mass of billions of dollars in fees and income to the managers is secured. Buffett has no reason to mislead...financial services firms have all the reason in the world to do so. I go with Buffett.

Hi, where I can rean news on this site?

Hi, how I can find the team who make this site?

Am I the only one who is noticing that Warren Buffet runs an actively managed fund (OK, a holding conglomerate, but they are similar in practice)? Why is he on this side? Is he just saying that hedge fund managers can't do as well as him?

Despite being spam, the above comment got me thinking that this site should really internationalize, either that, or add one of the many website translation options that are available.

The bet says 'a portfolio of funds of hedge funds', but does not name a specific portfolio of funds of hedge funds. Does this mean Warren Buffet believes the S & P 500 will outperform ANY fund of hedge funds measured over 10 years?
This is a much stronger statement than the S & P 500 will outperform one specific fund of hedge funds.
I'm fairly ignorant of the details here, but isn't the business model of these funds to convince investors to give them a bunch of money and then charge the investors fees? If the funds outperformed the 'average' consistently, then wouldn't it make sence for the fund to invest in itself rather than give it's customers the opportunity? The expected returns of running the fund must outperform the expected return to the fund's investors( customers ), otherwise why have customers (investors)? To get customers, the fund must only outperform the average of all funds, not the S & P 500. If there were a real lack of potential customers suceptible to fund manager's marketing departments' wiley ways then there would soon be less funds soon. That there are as many as there are, indicates the opposite.
It could very well be that when a fund does well over the short term, then that having-done-wellness is monetized as soon as possible by the fund as the basis for marketing hype. If the fund then subsequently does well, higher fees are charged. If the fund does bad, then it wasn't the fund manager's money anyway, they can always start another fund. But if the fund does well then it's the basis for more hype and still higher fees.
Maybe Buffet believes the 10 year time frame is enough to nullify any aparent smartness. He may believe that all such apparent smartness is ultimately attributable to dumb luck. Someone may flip a coin once a day for a month and come out 90% heads, but it doesn't mean he's skilled at flipping heads - over 10 years his heads to tails ratio will be approximately 1:1.

In the market, you have to have a trader (or fund manager) buying and someone selling in every transaction. Neither will profit immediately, because the broker will take a transaction fee from both. In time, as the price fluctuates, one of them will be seen as making the "right" move, and the other as making a "wrong" move. Give it some more time, and the positions might reverse. To be a "good" trader, you have to perfectly time your entry, and your exit. And you have to be able to do this consistently. Once you exit, you have to find another position better than the one you just left (otherwise you made the wrong move by closing your position).
There are too many unknown variables compounding at every transaction for anyone to be consistently right.

A very few (statistically insignificant amount) of people get lucky (sometimes for extended periods), but in the long run the only one who consistently wins in active trading is the broker collecting the fee at every trade.

Fortunately, you don't HAVE to trade to make money. There are companies who own assets that appreciate in value. They provide goods and services that add to our economy and earn the company a profit. The profit is returned by expanding the companies assets or paying the profit out as a dividend to owners.
Buy these companies and hold on to them as they appreciate and reap profits. This is how Buffet made his money. Not by trading (what an actively "managed" fund does to justify their "management fees").

If you have the time and skill to find the best companies, do it. If you don't have the time and skill, buy them all (an index fund) and hold them to reap their profits.

Give it time, and you will make more money holding onto the stock (and reaping the companies profits) then trying to guess which direction the market is going at every point in time.

http://www.thestreet.com/_yahoo/video/mutualfundrpt/10419432.html?cm_ven=YAHOOV&cm_cat=FREE&cm_ite=NA#10419432

It's not that there won't be market beating hedge funds / traders / active managers.
The point is that you can't pre-select who the "winners" will be. There will be way more "losers" (fail to beat the over-all market) than winners in the active trading game.

This guy makes an interesting analogy:
http://www.mymoneyblog.com/archives/2007/02/investing-in-actively-managed-funds-deal-or-no-deal.html

Buffett has a huge edge in this bet.

Of course in the long run Mr. Buffett is right, but what if around Christmas 2017 some members of the S&P 500 take a hit and Protege Partners happen to have shorted them? A decade-long dominance by the 500 could reverse at the last minute, only to return to average dominance by the 500 later.

This is a bet not only about long-run averages, but about volatility. Investors wouldn't be constrained to take out their retirement savings on a particular day of a particular year so Mr. Buffett still advises them well.

I think Buffett has a great chance to win this bet. But this doesn't mean that hedge funds and funds of funds cannot celebrate their short-lived success. I learnt that commercial bank and investment bank are the most important economic inventions in the 19th century. And I think hedge funds cannot be for the 21st century that's because it's also helpless in crisis now. I cannot take away the traditional businesses belonging to Wall Street either. You can also assume that for their sizes and the foundations of their beginning--leverage. Built on dangerous tools can only lead to failure. But if the transition of current economy takes at least for two decades, it equals to the counterpart's winning. That's a not so good news for the global economy. So, you can see, that Mr Buffett is indeed betting on our economy. I also bet on that, and I'll say that a change is in sight.

At first, I think that American economy becomes prosperous to be dominant to the world economy, and then I think that devaluation of U.S. dollar is unchangeable for the current trends, but since the crisis, no one has mentioned that point. You know, if USA government implement actions now and cannot wait till the outer markets respond to the crisis, then the government lets alone its future prosperity and I think this is irresponsible. So far, I have got new rescue ideas for the government because I haven't studied it yet. But the only sure thing I can guarantee is that the more actions, the quicker for the devaluation if government not manipulate it and I think it cannot. Oh, my God, a man-made crisis.Then the more governments, the better. USA's economy is very strong though.

I wonder how this coming (or should I say ongoing) recession will play out on this bet. Depending on the severity of this crisis it could take 2-8 years for an economic recovery.

I think Mr. Buffett's investment in GE and Goldman Sachs is not only a liquidity matter, but also a reputation and prediction matter in such a crisis which I think is way beyond value investment. There is no fresh news from his rival, he tops in this round.

I think this crisis is not the worst, but the most wide spread in the modern economy. I think this crisis has turned into stage 2 with backward trends, not recession to me. If this cannot stand strong, then a war is in sight. I think this means that governments should define it as soon as possible in key aspects. Hope my nonsense makes sense to experts.

Huge losses is in sight, but levels of investment is maintained, in which aspect, I bet that the economy will sooner as predicted be recovered.

Great quote today from Buffet on why he has chosen today (Oct 17th 08) to move $50 billion into the US Stock market:

"A simple rule dictates my buying: Be fearful when others are greedy and be greedy when others are fearful,"

The best, most valid or relevant argument so far: diminishing fees over time increasing probability of challenger (Protege) win. This is likely and was my first thought.

The only important argument missing: The agreement as discussed in June 23, 2008 Fortune, requires provision of audited annual results to Buffett. With the cash and connections he has...it wouldn't take much to play a little (chess/poker) with his opponent. Knowing their moves gives him an obvious edge - and he IS competitive, or he wouldn't have won so many financial matches (without spending the winnings...i.e. it must be about the thrill of competing). I believe the assets under management ratio is around 57:1 in favour of Buffett; ~3.5bill to 200billion?

Watch for updates in Berkshire's annual meeting!!

The best, most valid or relevant argument so far: diminishing fees over time increasing probability of challenger (Protege) win. This is likely and was my first thought.

The only important argument missing: The agreement as discussed in June 23, 2008 Fortune, requires provision of audited annual results to Buffett. With the cash and connections he has...it wouldn't take much to play a little (chess/poker) with his opponent. Knowing their moves gives him an obvious edge - and he IS competitive, or he wouldn't have won so many financial matches (without spending the winnings...i.e. it must be about the thrill of competing). I believe the assets under management ratio is around 57:1 in favour of Buffett; ~3.5bill to 200billion?

Watch for updates in Berkshire's annual meeting!!

I have talked with a predictor, who has told me Mccain will definitely win.

The G20 is going on very well, which seems to be the biggest event this month. As you can see, without strong backup from the society, it can reach nothing in essence. So, the time is really embarassing for investing gurus.

Today, I enthuiastically talked to my mother--an accountant for thirty-three years and a part-time insurance sales woman--about my readiness to supply those in need of cash with my own in terms of credit. Then she told me that was the last thing you want to do because when you'd repay for others' losses, my assets would also plunge. So I do know the problem, that is, too many institutions are just like me, and somehow they all acted as credit makers. So many that there is bare value.


So, the good start in the G20 summit this Saturday is to deal with the wide spreading credit makers. This is a project, like tracing down open market's transactions. Good luck!

Who are we kidding? There won't be a Manhattan Island in 2017, much less an S&P!

Who are we kidding? There won't be a Manhattan Island in 2017, much less an S&P!

Does anybody know if the hedge funds that Protege bet on were involved in the Madoff affair?

I suddenly find that "Shadows" from Alison Krauss is perfect rhythm for the current economic conditions. Would you agree?

I think discussions about the economy in Treasury Depart. is hot just like all over the U.S.. And this is really time-consuming, but Mr. Paulson really does a good job, only if... who knows to say what? I think this crsis has almost made me speechless.

By Hugh Son

Dec. 29 (Bloomberg) -- Billionaire Warren Buffett’s Berkshire Hathaway Inc. won a $224 million bet that Florida would escape major damage from hurricanes this year.

Florida’s option agreement that would have compelled Buffett to buy $4 billion of bonds to finance storm recovery will expire Dec. 31, Dennis MacKee, a spokesman for the State Board of Administration, said in an interview today. The state earlier paid Buffett $224 million in return for his commitment to buy the debt if needed. The calm season meant Florida had no need to raise the money.

http://www.bloomberg.com/apps/news?pid=20601087&sid=a8sNzCMHzgHk&refer=home

People say we need money. That's true. Where would you get it? That depends, international trade, debts, or etc.. I think the government can guarantee you that by salary like days in 1930s. Of course, no one mentions that to the point.

If Buffett says it, doe that make it happen? He must be very influential considering his success through the years.For this reason I say he will be proved right.
Fiona

I have to side with the challenger for the simple reason that I am aware of the history. There are currently hedge funds out there that have outperformed the S&P over a ten year consecutive span, net of fees. Sarah

Although the methodology is confidential, it would interesting to have an occassional (annual?) status report...

This bet compares the return of a market INDEX with a proxy for an INDEX of hedge funds, so ignore managers.

Assuming a “2-and-20” fee for each hedge fund and an additional “1-and-10” fee for the manager forming a fund of funds by selecting hedge funds, and ignoring the second component of the fee, the amount that the gross return of the fund index must exceed the cost-free return of the S&P 500 index is 3 percentage points plus trading costs. Thus if the S&P returns 10%, the hedge fund index must return 13% plus trading costs because 3% in fees and trading costs will be deducted from the market return of the hedge funds to yield a net of 10%.

Assume a loss of 10% in the gross return. The loss to the investor in the cost-free index is 10%. The loss to the investor in the hedge fund index is 10% plus the 3% fee plus trading costs. To get back to a 2-year average of zero, the cost-free index must return 11.11%. The hedge fund index must return 14.94% plus 2 years’ trading costs.

To average 10% over 2 years given a 10% loss in the first year, the cost-free index must return 34.44% in the second year. To provide a net return to its investors of 10% per year over 2 years given a 10% loss on investments in the first year, the hedge fund index must return 46.77% plus 2 years’ trading costs in the second year.

The hedge fund fee is a positive charge whether the investment return is positive or negative. This negative asymmetry applies each year and thus compounds over time as my simple example shows making it harder for the fee-carrying investment to keep pace with a cost-free index over time.

If the assumed fee structure moves lower, the odds for Protégé to win the bet increase. However, I don’t think any hedge fund average can deliver returns high enough to overcome peer competition, the asymmetry of the fee, and the compounding of returns over 10 years to match the cost-free S&P 500 index, even if the hedge fund investments have theoretical advantages.

"Both parties of this bet have agreed upon an adjudication methodology that has been approved by Long Bets. They have asked that it be kept confidential."

This is totally ridiculous. Why would they hide the way this bet is determined to have been won or lost? In order to maintain integrity on this site you should release that information.

My post dated April 6, 2009 misunderstood the bet. The actual bet is not clearly stated. I recommend that the reader access the link provided by Alexander Rose in his post dated June 9, 2008 to learn important details of this bet.

The link is to an article written by Carol Loomis, a regular contributor to Fortune and, it seems, a friend of Warren Buffett. There, you will learn that Buffett is betting against five specific funds of hedge funds (FoHFs) chosen by Protégé Partners, LLC. Buffett is betting an index return against the net return to investors of Protégé’s selection of 5 FoHFs over the 10-year period ending December 31, 2017.

Since Protégé is allowed to pick the 5 FoHFs, this bet is a variation of comparing a market index to the acumen of a stock picker. It seems that tax efficiency and the costs of administering each regime are also being contested since we are comparing what an investor can put in his pocket at the end.

A clearer statement of Bet #362 might read as follows: “Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a specific portfolio of funds of hedge funds chosen by Protégé Partners, LLC, when performance is measured on a basis net of taxes, fees, costs and expenses.”

We don’t know certain important details. For example, we know the S&P 500 index will survive the 10-year period, but can the same be said for each of Protégé’s FoHFs? Since these are funds of funds, they are much more likely to survive than any given hedge fund, but in the unlikely event one or more of the FoHFs fails, I would argue that it cannot be replaced and liquidation proceeds, if any, are returned to the investor. An implicit part of the bet is that the details of the bet at its inception should also survive the time period over which the bet is made. No survivorship bias allowed.

We are comparing the net return to investors of the S&P 500 index, as represented by the Admiral Class Shares of the Vanguard S&P 500 Index Fund, to the net return to investors of a selected, but unknown, group of 5 funds of hedge funds (FoHFs) selected by Protégé Partners, LLC over the 10-year period ending December 31, 2017.

Each side of a rational bet has a chance of winning (Mr. Buffett estimated his chance of winning this bet at 60% while Protégé is on record as thinking they have an 85% chance). A rational third party should make his/her own assessment of likelihood and put forward a judgement based on those odds.

The big hurdle against Protégé is its fees. The gross return of the Vanguard fund is reduced by only 7 basis points to provide the investor’s net return. The gross return of the FoHF investment is reduced by about 25%, if positive, then by a further 2½ percentage points (2½% of the value of the account). If I understand this correctly, this means that a gross FoHF return of 10% in a year is reduced by fees to only 5% to the investor, assuming a total take of 25% of profits, i.e. positive returns, (the performance fee) and a 2½% management fee charged by the two levels of management. The FoHF has to gross 3.33% each year just to return zero to the investor.

If the Vanguard fund grosses 10% in a year, the investor nets 9.93%. The FoHF would have to gross a return of 16.57% to provide the same net of 9.93% as the index investor receives. That’s a 65.7% higher REQUIRED return for just one year.

A research effort led by Princeton’s Burton Malkiel studied hedge funds over the period 1996 �? 2003. Among other results, working from the hedge fund fees prevailing during that time, he calculated that hedge funds over that period had to earn almost 50% more than market returns just to return to their investors 20% LESS than index funds after fees and taxes.

A key to judging this bet is to understand the Protégé fee structure, and I’m not sure I do. From the information provided, I have assumed a total fee charged by two levels of management of a FoHF of 2½% of the value of the account plus 25% of ANY positive return.

I assume the Vanguard fund tracks the total return of the S&P 500. As an exercise, I have looked at the total return of the S&P 500 over the 10-year period immediately preceding the bet (1998 to 2007).

A $100,000 investment on January 1, 1998 had a pure accumulation of $177,519 as at December 31, 2007. The Vanguard accumulation was $176,334, assuming a cost of 7 basis points per year. If the FoHF exactly matched the S&P 500 total return, the fees would have reduced the net accumulation to just $108,033. Clearly the FoHF must do better for their investors to enjoy the same accumulation.

How much better?

The S&P 500 total return in 1998 was 28.58%. The Vanguard return under Buffett’s arrangement would have been 28.51%. The gross return of the FoHF to yield the same net result as the Vanguard would have to have been 41.35%, some 12.84 percentage points higher.

The S&P return in 1999 was 21.04%. The Vanguard return would have been 20.97%. The required gross return of the FoHF to keep pace with Vanguard would have been 31.29%, 10.32 points higher.

The S&P return in 2000 was -9.11%. The Vanguard return would have been -9.18%. The required return of the FoHF would have been -6.68%, 2.50 points higher. Whenever the gross return is negative, the FoHF performance fee is zero and the required difference in returns shrinks to 2.50 percentage points.

The results of the remaining 7 years are set out in the order of (year, S&P 500 return, Vanguard return, required FoHF return).

(2001, -11.89%, -11.96%, -9.46%); (2002, -22.10%, -22.17%, -19.67%); (2003, 28.68%, 28.61%, 41.48%);

(2004, 10.88%, 10.81%, 17.75%); (2005, 4.91%, 4.84%, 9.79%); (2006, 15.79%, 15.72%, 24.29%);

(2007, 5.49%, 5.42%, 10.56%).

It is a well-understood principle of investing that different asset classes correlate less-than-perfectly with each other and that the weaker the correlations, the lower the total risk of the portfolio. Hedge fund investing is recognized as a separate asset class that correlates relatively poorly with the more conventional asset classes of stocks, bonds, and cash. This is one of the reasons hedge funds grew in popularity as a form of alternative investing.

In particular, if hedge fund returns do correlate poorly with equities, it is entirely possible to see in the next 10 years at least one year where the S&P 500 total return is positive while the Protégé FoHF return is negative. With respect to the bet, this would be a setback to Protégé’s chances of winning.

To illustrate, I prepared a simple 2-year example where in the first year, I assumed a gain of 5% for the S&P total return and a loss of 5% for the FoHF. Assuming a cost of 7 basis points for the Vanguard fund and a FoHF cost consisting of an annual fee of 2½% of the value of the account plus an aggregate performance fee of 25% of ALL positive returns, if the S&P total return in the second year is zero, the FoHF has to return 21.14% to catch up.

I have prepared a table of these results. I don’t know if the table will survive being put through the website editor and emerge in the same form in which it was prepared.

S&P TR VALUE FoHF RETURN VALUE

100,000 100,000
5.00% 104,930 -5.00% 92,500
0.00% 104,857 21.14% 104,857

Are the challengers allowed to do as Siman Li suggests and maintain a fungible group of 5 FoHFs by throwing out a poorly-performing hedge fund and replacing it by one seen to be performing better as time passes? That they are allowed to do this isn’t clear from the wording of the bet unless it is implied by the phrase “a portfolio of funds of hedge funds”. I didn’t interpreted the phrase this way, but I guess that is how active management of a FoHF would be done and how the second layer of management earns its fees.

With all the horror stories written of hedge funds halting redemptions, could Protégé quickly and easily switch capital from one hedge fund to another if performance was very poor? And if so, are there exit fees that might be charged?

In my post dated April 15, I made reference to a post by Siman Li and commented from that post. It turns out that Siman Li is a handle for a spammer who successfully infiltrated this bet and whose posts have since been removed by the keepers of this site.

The original source of the information on which I commented was provided by Zlatko Savic in a post dated June 10, 2008 under the caption "History does speak volumes".

The Hennessee Group LLC maintains an index of hedge fund performance known as the Hennessee Hedge Fund Index. Each month, over 1,000 hedge funds report their performance numbers to Hennessee Group LLC. The overall Hennessee Hedge Fund Index (HHFI) is calculated by taking an equally-weighted average of all the underlying funds in each individual style. All returns are reported to Hennessee Group LLC directly from the hedge fund manager and are net of fees. Hennessee Group does not publish directories, lists, or information on the managers that comprise the Indices.

It would seem that Protégé doesn’t even have to find hedge funds that outperform the HHFI. A $100,000 investment following the performance of the S&P 500 total return, less 7 basis points, accumulates to $176,334 over the 10-year period 1998 to 2007. Following the net performance of the HHFI over the same period, $100,000 accumulates to $250,762. Over the 15-year period 1993 to 2007, the corresponding accumulations are $442,396 for the S&P and $523,003 for the HHFI.

Both the 10-year and 15-year results are easy victories for Protégé, assuming they can select 5 FoHFs where each FoHF performs to the HHFI or better. Surely Buffett was made aware of all this, yet he still made the bet and thinks he has a 60% chance of winning (he would have to have had a lot of this information to make a reasonable estimate of his chances of winning).

Why would he do this? The whole hedge fund side of this bet is rather dark to external observers like me. A few aspects of the way hedge funds really work are known only to the players themselves. We might ask if the hedge fund data that we can access is reliable. We can’t check calculations and methodologies because the hedgies won’t give up their sources.

Certain hedge fund performance data (from 1993 forward) that I have referenced is found at the Hennessee website. You will also find there for most of those years the percentage of hedge fund managers that beat the S&P 500. Taking the 10-year period 1998 to 2007, this ranges from a high of 92% of managers in 2002 to a low of only 26% in 2006. However, this kind of information is qualitative and of limited use. A hedge fund manager can “beat the S&P”, but we need to know by how much. We need to know if the differences cover the fees.

Suppose a FoHF manager had an 80% chance of beating the S&P total return index each year. At these odds, his chance of doing so 10 years in a row is only 10.74%, meaning there is a better-than-91% chance that the S&P will beat him at least one year in ANY 10-year period. If we raise the 80% chance to 90%, there is still a 65% probability that the S&P will beat him at least one year. Any year the S&P beats the FoHF manager means he must earn high-enough returns in the following years to cover his fees AND catch up.

Under my assumption of fees for this bet, the FoHF manager must beat the S&P every year to avoid a catch-up situation. Since 1946, the required performance differential ranges from 2.50 percentage points (pp; any year the S&P return is negative) to 20.85 pp in 1954 when the S&P 500 returned 52.62%. The average required differential is about 8 pp.

How do these differences translate to a population of money managers? Again, performance is divided into quartiles but we are not told, for example, how much better “2nd quartile” is than “3rd quartile”. These performance increments will differ among quartiles in any given year and also among years.

As best as I can determine, the average one-quartile increment in equity investing is about 3 pp, so to get a performance 8 pp higher, I estimate the hedgies must perform, on average, an equity equivalent of about 2½ quartiles above the S&P each year.

The way to bet is with the long term trend & the first line of the challenger accepts that funds have historically underperformed. That being the case it seems Buffett is likely to win it.

It looks like both parties, though particularly Protege, are risking their $1 million to advertise how they stand behind their financial acumen.

I believe Mr. Buffet said he would provide updates to this bet annually at the Berkshire shareholder meeting. Does anyone know if an update has been provided? I am very curious to know how the fund of hedge funds performed in its first year of this bet!

While I agree with Buffett that hedge funds don't usually do better than passive investment, the fact that these fund of funds can invest in broader markets beyond SP500 will provide them with an advantage.

If the fund of funds were limited to investing only in US large caps, then the odds would be more in Buffett's favor.

regards

I would agree with this. The problem with human initiated buying and selling is that humans tend to act on fear and greed, so they will tend to buy to high and sell to low. Of course there are always outstanding fund managers but taken as a group they do not perform so well, which is crazy considering the fees that are extracted.

Carol Loomis sent us this update:

Remember “Buffett’s Big Bet” (see fortune.com), in which the noted investor and Ceo of Berkshire Hathaway maintained that an S&P 500 index fund would outperform five funds-of-hedge-funds over 10 years? Well, the results for the first lap, the ago-nizing year of 2008, are finally in, and the funds-of-funds soundly whipped the index. Vanguard’s S&P 500 Admiral shares, the index fund “bought” by Buffett, were down 37.02%. on the average, and net of all fees, costs, and expenses, the five funds-of-funds backed by Buffett’s opponent, Protégé Partners llC, a new York money-management firm, delivered ~23.9%.

Considering that hedge funds can and do sell short, and that they are not limited to investing in stocks, Protégé’s victory in a bear market year like 2008 was not surprising to anyone involved in the bet. Ted Seides, the Protégé partner who engineered the bet with Buffett, says that until September of that year the five funds-of-funds were in fact doing well enough that they still anticipated achieving the up year that hedge fund seek to deliver, even in difficult markets. “But when markets failed in the aftermath of the Lehman bankruptcy,” says Seides, “the funds couldn’t avoid the storm.”

Which funds are these, you ask? The bet stipulates that their identities would not be disclosed. Buffett, however, knows their names and has seen their audited results. About his trailing position, he says, “I just hope that Aesop was right when he envisioned the tortoise overtaking the hare.”

The reader will note that we said the results of the bet are “finally” in, and therein lies a little story. originally, the thought was that an update on the bet would be announced each year at Berkshire’s annual meeting, held in late spring. But the five funds-of-funds did not have audited financial statements at that time, which made Buffett unwilling to announce results. only in late october, when the last of the five funds finally delivered its audited figures to Protégé, were complete results known. They were very close to what Protégé had earlier estimated they would be, so it is likely that next year Buffett will indeed announce 2009 “approximate” results at Berkshire’s meeting in the spring.

The author of this article is both a friend of Buffett’s and the editor of his chairman’s letter in the Berkshire Hathaway annual report.

Comments are temporarily closed.

Due to SPAM problems we have disabled commenting on Long Bets until we can institute automated filtering. Sorry for the inconvenience.