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Warren Buffett’s Bet: Index Funds vs. Hedge Funds

Seth Jentner12/27/2013

How would you like to bet a million dollars that your investment strategy will work best over the next 10 years?

Billionaire-investor Warren Buffett is running ahead on a bet with two hedge fund managers that the S&P 500 Index would beat an index of hedge funds. Buffett contends that the active management and high fees associated with hedge funds cannot beat the market. His proxy in this bet is the Vanguard S&P 500 Index fund, which, like most index funds, has low management expenses and does not try to select the best stocks or try to time when to be in or out of the market.

The hedge fund managers, Jeffrey Tarrant and Ted Seides of Protégé Partners in New York, contend that hedge funds have an advantage because they can bet on rising and falling prices of all types of assets, including currencies, commodities, stocks and bonds. They said hedge fund managers “with the ability to sort the wheat from the chaff” will reap big enough profits to outweigh their extra expense. Hedge funds typically charge a 2% annual management fee plus take 20% of the profit. They constructed an index of five hedge funds of funds—essentially funds that pick and choose from among all hedge funds.

The bet began January 1, 2008 as a major financial crisis was breaking. In the first year, the hedge funds outpaced the market, losing 24% compared to a loss of 37% on the S&P 500 fund. But in subsequent years, the market pulled ahead. After the stock market rally of 2012, the S&P 500 fund was up 8.69% for the whole period, compared to 0.13% for the hedge funds.

The bet lasts for 10 years. The loser will make a $1,000,000 contribution to the charity of the winner’s choice. It will be interesting to find out who wins this bet.

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