The ‘Million-Dollar Bet’ — Warren Buffet vs. the Hedge Funds … With a Divine Thumb on the Scales

The ‘Million-Dollar Bet’ — Warren Buffet vs. the Hedge Funds … With a Divine Thumb on the Scales May 18, 2016

by Tim Weinhold

(Originally published May 10, 2016)

One of the more instructive bets in investing history is close to paying off. Several years ago, Warren Buffet opined that an ordinary stock index fund would, over time, outperform the best hedge funds. ‘Put your money where your mouth is’ challenged Ted Seides, at the time head of Protege Partners, a New York City money management firm that runs funds of hedge funds.

After a fair amount of back-and-forth negotiating, the two agreed on the now-famous ‘Million-Dollar Bet’ in which Buffet picked a plain vanilla S&P 500 index fund from Vanguard and Protege placed its faith in a carefully selected set of five funds of hedge funds whose returns would be averaged. The winner would be whichever investment approach achieved the highest return over ten years, net of fees, costs, and expenses.

For ‘skin in the game’ both Buffet and Protege put up half the cost of a zero-coupon Treasury bond that would be worth $1 million at the conclusion of the bet, the entire value of which would be donated to the winner’s charity of choice. (The terms were subsequently altered so that the likely donation value will now be approximately $1.5 million.)

For anyone familiar with why ‘the sage of Omaha’ is widely considered the most successful investor of all time, Buffet’s original pronouncement seems a tad odd. Buffet is the epitome of an active investor, making carefully-considered, case-by-case decisions to acquire individual stocks, or entire companies. His investing career has been premised on the idea that it is possible — for someone with sufficient savvy and discipline — to consistently beat the market. His stellar results over decades have certainly proven that conviction.

And yet Buffet hadn’t merely boasted that he could personally achieve superior returns to those of hedge funds. Rather, he promised that even an ordinary passive stock index fund could beat the hedge fund managers — the very demigods of the 21st century investing universe. That’s a bit like saying, ‘My skinny kid brother can beat up on Arnold Schwarzenegger and Sylvester Stallone and three of their baddest friends.’

The ten-year deadline is drawing close — the bet will conclude at the end of next year. So where do things stand? Through the end of 2015, Buffet’s Vanguard S&P 500 index fund is up 65.67%. The five funds of hedge funds are, on average, up less than a third of that amount: 21.87%. It is all but a mathematical certainty that Buffet and his index fund will win the Million-Dollar Bet.

65.67% vs. 21.87%. By anyone’s standards, that is a remarkable difference in investing performance. Why should this be the case? In particular, why should a no-brainer passive index fund radically outperform a composite of top hedge funds run by some of the smartest (or, at least, best paid) guys on Wall Street? There are two explanations, one simple and obvious, the other neither simple nor obvious. The second one, however, goes to the heart of why business investing makes good sense in our good God’s universe and, as well, to the night-and-day difference between investing and trading.

Hedge Fund Fees

First, the simple, obvious explanation. Hedge funds charge extraordinarily high fees — typically the now- famous 2&20 formula originally introduced by Theodore Forstmann at the founding of Forstmann Little and Company. Under this approach, hedge fund managers (and others) charge an annual 2% fee on assets under management, and keep an additional 20% of the upside generated on their capital.

“The level of wealth creation driven by 2&20 has been nothing short of awe-inspiring,” writes Roger Martin, former dean of the business school at the University of Toronto in his excellent book, Fixing the Game. He adds:

The Forbes 400 list identifies and ranks the richest Americans. Within thirty years of Forstmann’s creation, it was clear that the best way to achieve a place on the list was to invest other people’s money and get paid on the basis of the 2&20 formula. Of the richest four hundred Americans on the 2010 list, fifty got there thanks to the 2&20, versus forty for technology, thirty-nine for media, thirty-eight for oil and gas, and twenty-eight for retailing.

Flat out, 2&20 is the greatest wealth producer of our lifetime. And for some, even 2&20 isn’t enough. The most successful hedge funds have argued that their very success should allow them to extract yet a greater percentage of the upside of their investments. James Simons, for instance, founder and controlling shareholder of hedge fund Renaissance Technologies, isn’t satisfied with 2&20; at latest check, Renaissance charges its clients 5 percent per year for assets under management plus 36 percent carried interest. It is nothing short of breathtaking.

And, of course, a fund of hedge funds layers its own fees on top of the underlying funds’ fees. All of which has much to do with why Buffet made his original pronouncement. He was convinced that the fees charged by hedge funds were exorbitant and that actual returns to investors — net of those fees — would underperform even a plain vanilla equity index fund. More than eight years into the Million-Dollar Bet, it’s clear Buffet was right.

But there is a second, more important explanation for the dramatically different investing outcomes achieved by the S&P 500 index fund versus the hedge funds. The investment rationale underlying an equities index fund is that the revenues, profits, and equity value of companies tend to grow larger over time. In fact, this is the basic rationale behind pretty much every approach to investing in equities. (As will be evident shortly, strategies for trading or arbitraging equities, or anything else, rely on entirely different rationales for success).

This assumption about the increasing economic value of companies over time is, in fact, so widespread, and so deep, that it is all but unconscious. And so it probably strikes absolutely none of us as surprising that the Vanguard fund grew in value by more than 65% over the past eight years. That’s because our unconscious expectation is ‘Of course it should grow attractively in value — because that’s simply what companies, and their equities, tend to do.’

Why Does Business Prosper?

But at the risk of sounding mindlessly metaphysical, why should this be the case? Why do companies’ revenues, profits, and equity value so often grow over time? In other words, why does business (tend to) prosper? After all, suppose Buffet had picked a rather different ‘investing’ approach. Suppose his choice was to have someone make a continuing series of bets at a roulette wheel or blackjack table. If that ‘investing’ strategy had delivered a 65% return over eight years, we would all be astonished. Honestly, we would be shocked if the bettor hadn’t lost his or her entire bankroll within the first several hours. And yet we consider a 65% return from equities as entirely to be expected. Why, exactly, should that be the case?

Here’s why. The essential nature of business is to create products that add value to customers. Otherwise, would-be customers simply wouldn’t buy. Which means that the intrinsic effect of business, practiced rightly, is to improve the lives of customers and make the world a better place. And that means there is a direct relationship between business and the kingdom of God.

Jesus, Paul, and James all teach that ‘Love your neighbor’ is the essential kingdom of God behavior. In fact, it is the moral foundation and First Principle of God’s kingdom. And if love is the hallmark behavior in God’s kingdom, then life (growth, abundance) is its hallmark outcome. Jesus makes this explicit when he says, “The thief comes only to steal and kill and destroy. I came that they may have life and have it abundantly,” (John 10:10, ESV).

Jesus’ statement makes clear that there are, in fact, two opposed kingdoms, each with their respective hallmark behavior and outcome. The bedrock behavior in God’s kingdom is loving and serving others. But in the kingdom of the thief, it is serving oneself at others’ expense. One behavior brings about the abundant life (shalom) characteristic of God’s kingdom. The other brings the death and decay typical of the enemy’s kingdom. These outcomes flow from the fact that God has placed us in a moral universe — i.e., a universe in which, generally and over time, righteousness is rewarded and unrighteousness reproved. In contemporary vernacular, a universe in which ‘what goes around comes around.’

The default dynamic of business is to create products that improve the lives of customers. This is, whether intentionally or not, ‘Love your neighbor’ behavior. Which means that in the moral universe of our good God — where both good and bad get rewarded in kind — creating value for customers and others redounds to benefit business as well. Business, rightly practiced, therefore, both sows and reaps blessing (life, growth, abundance). Which is why the typical outcome for business, and business investing, is growth. And it’s why none of us are surprised that Buffet’s plain vanilla index fund is up 65% over the past eight years.

Wealth Creation vs. Wealth Appropriation

Hedge funds, however, make money quite differently. In Wall Street parlance, they are much more about ‘trading’ than ‘investing.’ There is a world of difference between the two.

In the simple base case1 for investing, investors give their money to a company (let’s say via an IPO) in exchange for shares of equity. The company uses this new capital to grow their business. Meaning the company produces more of the product by which it adds value to customers. As well, it creates more jobs, both directly and via suppliers, grows revenues and profits, and pays more taxes to fund the roads and schools and police and fire fighters a prospering society requires. In the process the company becomes more valuable, as do the shares of its investors. This is a total win-win outcome.

Sometimes hedge funds make similar investments. More often, though, they make ‘trades’ — speculative bets — instead. And in the nature of bets, one side wins, the other loses. In the simplest case, a blackjack bettor wagers on his or her hand. If successful, the bettor wins money and the house loses. More often, it’s the other way around. Regardless, no wealth is created, it’s only moved from one party to another. The same is true for hedge fund trades. If the trade is successful, the hedge fund wins and someone else loses. There’s no win-win, it’s all win-lose. Roger Martin describes it this way, “Hedge funds [are] simply and clearly traders, not builders. Hedge funds play entirely, completely, and utterly in a zero-sum game.”

He then contrasts the wealth creation of business (and business investing) from the wealth appropriation of hedge funds:

One might argue that [famous hedge fund traders] James Simons and John Paulson are no different than Bill Gates; after all, each is exceedingly rich thanks to a company he started. But there are fundamental differences . . . Gates became wealthy by providing a valued product to his customers. His wealth is thus derived from a positive-sum game. Microsoft is better off and its customers are too; no one needed to lose value in order for Bill Gates to get rich. Simons and Paulson, on the other hand, had to take their money from someone else. For them to get rich, their trading partners had to lose vast sums.

Win-win happens when business creates value for customers and others and, as a byproduct, reaps profit as a reward — i.e., creates wealth. This reflects the foundational dynamic of the kingdom of God. Win- lose, by contrast, extracts value. It is the ‘serve oneself at the expense of others’ behavior central to the enemy’s kingdom. There’s no wealth creation, only wealth appropriation (plunder). Such behavior eventually reaps the death (decay, deterioration) endemic to the thief’s kingdom.

Warren Buffet believes hedge fund fees are exorbitant and bad for investors. But that’s only one part of why he will win the Million Dollar Bet. More so, he will win because in the moral universe of our good God there is a divine thumb on the scales in favor of ‘Love your neighbor’ value creation and against value extraction. Which means plunder works really well . . . until it doesn’t, until its day of reckoning. And that’s why everyone, religious and irreligious alike, knows that ‘karma is a bitch’ and ‘the house always wins.’ Both axioms simply reflect, of course, what the Apostle Paul wrote two millennia ago: “Do not be deceived, God is not mocked, for whatever one sows, that will he also reap.”

Notes:

  1. Even in the more typical case where equities are purchased from other shareholders rather than from the company itself, the liquidity made possible by this secondary market for equities allows corporations to raise investment funds more easily and cheaply than would otherwise be the case. That said, there are good arguments for tax policies designed to create more long-term shareholders versus short-term share traders.

The material provided herein has been provided by Eventide Asset Management, LLC and is for informational purposes only. Eventide Asset Management, LLC serves as investment adviser to one or more mutual funds distributed by Northern Lights Distributors, LLC, member FINRA. Northern Lights Distributors, LLC and Eventide Asset Management are not affiliated entities.

4304-NLD-4/25/2016


Browse Our Archives

Follow Us!