Warren Buffett and the $1million bet

Last year saw the conclusion of a 10-year wager between Warren Buffett, chairman of Berkshire Hathaway Inc., and Ted Seides, a New York hedge fund consultant.

Seides responded to a public challenge issued by Buffett in 2007 regarding the merits of hedge funds relative to low-cost passive vehicles. The two men agreed to bet $1 million on the outcome of their respective investment strategies over the 10-year period from January 1, 2008, through December 31, 2017.

Buffett selected the S&P 500 Index, Seides selected five hedge funds, and the stakes were earmarked for the winner’s preferred charity. The terms were revised midway through the period by converting the sum invested in bonds to Berkshire Hathaway shares, so the final amount is reported to be in excess of $2.2 million.

The 10-year period included years of dramatic decline for the S&P 500 Index (–37.0% in 2008) as well as above-average gains (+32.4% in 2013), so there was ample opportunity for clever managers to attempt to outperform a buy-and-hold strategy through a successful timing strategy. For fans of hedge funds, however, the results were not encouraging.

For the nine-year period from January 1, 2008, through December 31, 2016, the average of the five hedge funds achieved a total return of 22.0% compared to 85.5% for the S&P 500 Index.(1) (Results for 2017 have not yet been reported.)

Having fallen far behind after nine years, Seides graciously conceded defeat in mid-2017. But he pointed out in a May 2017 Bloomberg article that in the first 14 months of the bet, the S&P 500 Index declined roughly 50% while his basket of hedge funds declined less than half as much. He suggested that many investors bailed out of their S&P 500‑type strategies in 2008 and never participated in the recovery. Hedge fund participants, he argued, “stood a much better chance of staying the course.”

Seides makes a valid point—long run returns don’t matter if the strategy is abandoned along the way. And there is ample evidence that some US mutual fund investors sold in late 2008 and missed out on substantial subsequent gains. But do hedge funds offer the best solution to this problem?

We think educating investors about the unpredictability of capital market returns and the importance of appropriate asset allocation will likely prove more fruitful than paying fees to guess where markets are headed next. A hypothetical global diversified allocation of 60% equities and 40% fixed income (2), still outperformed the hedge fund basket over the same nine years (41.8% vs 22.0% in total returns).

Over any time period some managers will outperform index-type strategies, although most research studies find that the number is no greater than we would expect by chance. Advocates of active management often claim that this evidence does not concern them, since superior managers can be identified in advance by conducting a thorough assessment of manager skills. But this 10‑year challenge offers additional evidence that investors will most likely find such efforts fail to improve their investment experience.

EXPECT THE UNEXPECTED

Financial markets surprised many investors in 2017, but then again, they have a long history of surprising investors. For example, from 1926–2017, the annualized return for the S&P 500 Index was 10.2%. But returns in any single year were seldom close to this figure. They fell in a range between 8% and 12% only six times in the last 92 years but experienced gains or losses greater than 20%, 40 times (34 gains, six losses).

Investors should appreciate that, many times, realised returns may be far different from expected returns.

For a number of investors, 2017 was a paradox. The harder they tried to enhance their results by paying close attention to current events, the more likely they failed to capture the rate of return the capital markets offered.

New Year’s resolutions?

1. Keep informed on current events as a responsible citizen.

2. Let the capital markets decide where returns will be generated.

RISKS

Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful. Diversification neither assures a profit nor guarantees against loss in a declining market.

1. Hedge fund data from Chairman’s Letter, Berkshire Hathaway Inc. 2016 annual report.

2. Global diversified allocation is the Dimensional World Allocation 60/40 Index (USD). Indices cannot be invested into directly. See Appendix

for index description.

APPENDIX

Dimensional World Allocation 60/40 Index

Rebalanced monthly. For illustrative purposes only.

The balanced strategy index is not a recommendation for an actual allocation. All performance results are

based on performance of indices with model/back-tested asset allocations; the performance was achieved with the benefit of hindsight; it does not represent actual investment strategies, nor does it reflect fees associated with investing. Actual results may vary significantly.

The underlying Dimensional indices of the balanced strategy index have been retrospectively calculated

by Dimensional Fund Advisors LP and did not exist prior to their inceptions dates. Other periods selected may have different results, including losses.

Back-tested index performance is hypothetical, is not actual performance and is provided for informational

purposes only. Back-tested performance results assume the reinvestment of dividends and capital gains.

Additional information is available upon request.