The Tortoise and the Hare

For years Warren Buffett offered a famous bet with no takers. He contended that over ten years an S&P 500 Index Fund would beat any hedge fund chosen in advance over the same time period. The terms of the bet? The loser would donate $1,000,000 to the charity of the winner’s choice. Finally, Protégé Partners accepted the bet if they could use the average return of 5 hedge funds rather than any single hedge fund. Warren Buffet accepted these terms. By the way, the names of the five hedge funds will not be released until the end of the bet.

The logic of Buffet’s bet is based on fees. Vanguard S&P Index Fund Admiral Shares charge a paltry 0.06% per year on a minimum investment of $10,000. Actively managed hedge funds typically charge 2% per year, plus 20% of any profits! Buffet believes that no one is smart enough to deserve that kind reward from somebody else’s money.

That was four years ago. In 2008, the first year of the bet, Protégé lost 23.9%. Warren Buffet’s Vanguard Admiral Shares lost 37%. Vanguard won in 2009, 2010, and 2011. Today Protégé’s five fund average is down 5.89% and the Vanguard 500 is down 6.27%. Not something to write home about. Allow me a brief aside about claims by various funds. Let us say a certain fund increased 100% in the first year, and then lost 50% in the second year. That fund could claim an average increase of 25% per year when in fact the investor would not have made a penny. Be certain what the salesman is talking about when you listen to such claims.

What I find truly comical about the bet is the collateral. Buffet and Protégé each put up $320,000 to buy a zero coupon Treasury security that will be worth $1,000,000 at the conclusion of the bet. Due to falling interest rates over the same time period, the bond is currently worth $930,000. A total increase of 45% in the first four years! Of course the maximum value it can obtain is $1,000,000. Still that is something to think about.

Who knows? Maybe this year Buffet’s tortoise and Protégé’s hare may both break even. This is a good example to the extreme importance of large early losses in an investment. If, for example, an investment loses 50% of its value in the first year, it then must increase by 100% just to break even. That is not a common outcome.

And Please! Let’s be careful out there.