The Berkshire–Protégé Index Bet
high confidence — compiled with source citation from the investment brain.
The Berkshire–Protégé Index Bet
The Berkshire–Protégé Index Bet
In his 2005 annual report Buffett argued that active investment management by professionals, in aggregate, would over a period of years underperform what rank amateurs could earn by sitting still in a low-cost index fund. He then "publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds" that would match an unmanaged S&P 500 index fund over ten years.
Terms of the bet
One manager — Ted Seides, co-manager of Protégé Partners — took the other side. The wager was finalized on December 19, 2007, running January 1, 2008 to December 31, 2017. Buffett's side was a Vanguard S&P 500 index fund; Protégé's side was five "funds-of-funds" (averaged), which in turn held interests in more than 200 underlying hedge funds. The formal proposition, posted on Long Bets, read:
Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.
Each side funded a $500,000 share of an eventual $1 million charitable prize by buying $318,250 of zero-coupon Treasury "strips"; Buffett designated Girls Inc. of Omaha as his beneficiary.
Year by year
The final scorecard, as printed in the 2017 letter (per-fund and index annual returns):
| Year | Fund A | Fund B | Fund C | Fund D | Fund E | S&P Index |
|---|---|---|---|---|---|---|
| 2008 | -16.5% | -22.3% | -21.3% | -29.3% | -30.1% | -37.0% |
| 2009 | 11.3% | 14.5% | 21.4% | 16.5% | 16.8% | 26.6% |
| 2010 | 5.9% | 6.8% | 13.3% | 4.9% | 11.9% | 15.1% |
| 2011 | -6.3% | -1.3% | 5.9% | -6.3% | -2.8% | 2.1% |
| 2012 | 3.4% | 9.6% | 5.7% | 6.2% | 9.1% | 16.0% |
| 2013 | 10.5% | 15.2% | 8.8% | 14.2% | 14.4% | 32.3% |
| 2014 | 4.7% | 4.0% | 18.9% | 0.7% | -2.1% | 13.6% |
| 2015 | 1.6% | 2.5% | 5.4% | 1.4% | -5.0% | 1.4% |
| 2016 | -3.2% | 1.9% | -1.7% | 2.5% | 4.4% | 11.9% |
| 2017 | 12.2% | 10.6% | 15.6% | N/A | 18.0% | 21.8% |
| Final gain | 21.7% | 42.3% | 87.7% | 2.8% | 27.0% | 125.8% |
Average annual gain: 2.0% / 3.6% / 6.5% / 0.3% / 2.4% versus 8.5% for the index. Fund D was liquidated in 2017. The 2017 letter summarizes the shape of the result: the five funds got off to a fast start, each beating the index fund in 2008, but then the roof fell in and in every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund.
The verdict: fees are the whole story
Buffett's interpretation is that the loss was not about skill but about cost. He estimates that over the nine years "roughly 60% – gulp! – of all gains achieved by the five funds-of-funds were diverted to the two levels of managers", via the standard "2 and 20" hedge-fund fee plus a further ~1% fund-of-funds layer. The 2016 letter's epigram — "Fees never sleep" — is compressed in the 2017 letter to the observation that performance comes and goes, but fees never falter.
He also notes the market environment was "neutral" rather than hostile: a 7.1% compounded index return through 2016 was one that could easily prove typical for the stock market over time, so the hedge funds could not blame a bear market.
The bet is the concrete, decade-long version of the theoretical claim in efficient-market-hypothesis: in aggregate, active managers are the market minus their costs. Its secondary lesson — that "markets are generally rational" but "occasionally do crazy things", rewarding those who can "disregard mob fears or enthusiasms" — points toward keynes-beauty-contest and second-level-thinking. The underlying logic is the arithmetic of indexing, not a talent judgment, and it echoes the quality-vs-statistical-cheap fork: Buffett's side won by refusing to pay for selection that, net of fees, could not beat the cheapest available alternative.
See also
Sources
berkshire-hathaway/Letters-Markdown/2016 - Letter to Shareholders.mdberkshire-hathaway/Letters-Markdown/2017 - Letter to Shareholders.md