Commentary by Andy Clarke, senior investment strategist in Vanguard Investment Strategy Group.
When global sharemarkets closed at the end of 2017, Warren Buffett strode into the winner’s circle to claim more than US $2 million (about AUD 2.5 million) for Girls Inc. of Omaha, Nebraska.
In 2007, Buffett wagered that no investment professional could pick a portfolio of at least 5 hedge funds that would outperform a low-fee S&P 500 index fund over the subsequent decade. (He chose Vanguard 500 Index Fund, the first index mutual fund, introduced to US investors by Jack Bogle in 1976.)
New York-based Protégé Partners accepted the challenge. At stake was a donation to a charity of the winner’s choice. By the end of 2016, Buffett’s lead had become so sizable that he declared victory.* Protégé Partners conceded. Now it’s official.
Why the bet matters … and doesn’t
The bet matters because it illustrates principles that can help us with our portfolios:
- First, the amount we pay to invest determines our share of the rewards from any investment strategy, whether it’s a large-cap share index fund or a complex hedge fund.
- Second, we invest to meet a financial goal.
The bet doesn’t matter, on the other hand, because its measure of success may have nothing to do with reaching our goals. If we’re saving for retirement, a child’s education or a home, beating a hedge fund or the S&P 500 Index isn’t the point.
The less you pay, the more you keep
Investment performance is always time-dependent. A strategy that works in a single 10-year period may not be as successful in the future. In the next 10 years, perhaps Protégé Partners will prevail with its more diversified mix of asset classes and strategies. Who knows?
What Buffett made clear, however, is the less you pay, the greater your share of the returns produced by any investment—a mathematical reality too easily overlooked.
The table below shows US S&P 500 index funds ranked by their expense ratios, grouped in quartiles (from lowest to highest costs), with the average expense ratio and 10-year return calculated in each quartile.
Over the 10 years of Buffett’s bet, US S&P 500 index funds with the lowest costs returned 8.37%, almost 99% of the index’s 8.50% return. Funds with the highest costs returned 7.39%—only 87% of the index’s return.
Average annualised returns of S&P 500 index funds by cost quartile, 31/12/2007–31/12/2017
Sources: Vanguard, using data from Morningstar.
If you wanted to invest in an S&P 500 index fund, the lowest-cost S&P 500 index funds would’ve delivered almost all of the index’s gains, accelerating your progress toward your goals.
In early 2017, Buffett wrote, "I estimate that over the nine-year period roughly 60%—gulp!—of all gains achieved by the 5 funds-of-funds were diverted to the two levels of managers."* (The first level is fees charged by the underlying hedge fund managers. The second level is fees levied by the manager who selects these managers.)
If returns are high enough, maybe an investor would be happy to walk away with only 40% of the gains. But superior returns are hard to sustain. And your ability to meet your goals depends not only on the success of your chosen strategy but also on your share of its returns.
Eyes on the goal
The bet’s prize—a charitable contribution—is a reminder that investing isn’t simply a battle of wits waged in the capital markets. It’s an undertaking that can improve lives.
As The Wall Street Journal explained, "The real winner of Warren Buffett’s 10-year bet against hedge funds is Girls Inc. of Omaha." Girls Inc. will use Buffett’s prize to cover the cost of "transitional housing for 16 young women who are aging out of foster care."**
We can never know which strategy or asset class will outperform over a given period. We can only control how much we pay. And the greater our share of a given strategy’s returns, the better our ability to meet our goals.
*Berkshire Hathaway Inc., shareholder letter, 25 February 2017.
**Nicole Friedman, "Buffett wins his hedge-fund bet—and this nonprofit wins bigger," The Wall Street Journal, 30 December 2017.