Warren Buffett Just Won a 10-Year Million-Dollar Bet: Here's Why

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Superinvestor Warren Buffett has recommended never betting against America, noting in his 2015 letter to shareholders: "For 240 years it's been a terrible mistake to bet against America, and now is no time to start. ... America's golden goose of commerce and innovation will continue to lay more and larger eggs."

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It's also smart not to bet against Buffett himself, as he has just won a 10-year-long, $1 million bet, gifting his winnings to Omaha nonprofit Girls Inc.

Trash-talking hedge funds

Buffett and his business partner Charlie Munger have long criticized hedge funds, in large part due to their hefty fees. At the most recent annual meeting of their company, Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), Buffett explained:

If you go to a dentist, if you hire a plumber, in all the professions, there is value added by the professionals as a group compared to doing it yourself or just randomly picking laymen. ... In the investment world it isn't true. The active group, the people that are professionals in aggregate, are not, cannot, do better than the aggregate of the people who just sit tight.

Munger, meanwhile, has expressed particular scorn at the typical compensation scheme of hedge fund managers, wherein they collect 2% of assets every year regardless of the fund's performance (or underperformance) and take 20% of the gains in years when the fund has a positive return. At a 2006 annual meeting of Munger's own company, Wesco, he cracked:

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You ask a hedge fund operator why they charge 2 and 20, and they say 'because I can't get 3 and 30.' ... [For hedge funds], it's not about thinking what is fair and right -- but merely 'how much can I get?' It's a ghastly culture... there will be terrible scandal in due course.

Munger has also noted, "The investing world is just a morass of wrong incentives, crazy reporting and, I'd say, a fair amount of delusion."

Buffett's no fan of the 2-and-20 fee plan, either: "If you even have a billion dollar fund and get two percent of it, for terrible performance, that's $20 million. In any other field, it would just blow your mind."

The bet, explained

In his 2016 annual letter to shareholders, Buffett explained how the bet arose:

In Berkshire's 2005 annual report, I argued that active investment management by professionals -- in aggregate -- would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of "helpers" would leave their clients -- again in aggregate -- worse off than if the amateurs simply invested in an unmanaged low-cost index fund.

He offered to bet any investment professional $500,000 that a low-cost Vanguard S&P 500 index fund would outperform his opponent's group of at least five hedge funds over a period of 10 years.

I then sat back and waited expectantly for a parade of fund managers -- who could include their own fund as one of the five -- to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line? What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man -- Ted Seides -- stepped up to my challenge.

The results

It has been clear for years that Buffett seemed likely to win the bet, and as of the end of 2017, he officially did. Hedge funds' returns are not publicly available, but in his 2016 letter to shareholders, Buffett shared the results of the bet over its first nine years.

In every year except 2008, when the U.S. economy was in a deep recession, the S&P 500 outperformed the average gain or loss of the five hedge funds. Check it out:

Year

Hedge Fund Average Return

S&P 500 Index Fund Return

2008

(23.90%)

(37%)

2009

16.10%

26.6%

2010

8.56%

15.1%

2011

(0.42%)

2.1%

2012

6.80%

16%

2013

12.62%

32.3%

2014

5.24%

13.6%

2015

1.18%

1.4%

2016

0.86%

11.9%

Through the first nine years of the bet, the S&P 500 returned a total of 85.4%. The hedge funds averaged 22%, with the best returning 62.8% and the worst returning a frankly abysmal 2.9% over nearly a decade.

How about this last year? Well, the S&P 500's performance wasn't too shabby: It gained more than 19%. Over the entire decade, the five hedge funds' average annual gain was 2.1%, while the S&P 500 averaged 7.1%. It wasn't exactly a nailbiter of a finish.

What happened?

Buffett didn't win the bet purely due to chance. There were a few factors that contributed to the S&P 500's strong returns and the hedge funds' disappointing performance. It's easy to point to hedge funds' hefty fees, which drag down net returns, but the hedge funds underperformed the index significantly even without counting fees.

Hedge funds face many challenges that managed mutual funds do: Their managers often feel pressure to outperform in the short term in order to please their shareholders and attract more shareholders, so they jump in and out of investments in the pursuit of quick profits. This activity alone generates costs through commissions and capital gains taxes.

By contrast, an index fund simply holds the same securities that are in the index. It has no need to research other investments or to buy and sell securities except in those rare instances when the underlying index adds or drops some components. Buffett has often sung the praises of inactivity in investing: "Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell."

Buffett has also said that "lethargy, bordering on sloth should remain the cornerstone of an investment style."

Indeed, Buffett has even said that when he dies, much of his personal wealth will be put in an S&P 500 index fund for his wife's benefit, and he has recommended index funds for most investors.

Buffett gets a bonus

An interesting twist in this story is that Buffett ended up winning not $1 million, but $2.2 million instead of the originally anticipated $1 million. That's because, mid-bet, the wagerers changed the rules a bit. Originally, they each invested about $320,000 into bonds that were expected to grow over the decade, ending up worth $500,000 each. However, interest rates dropped in the bet's early years, boosting the value of their investments. In 2012, they agreed to put their money into 11,200 shares of Berkshire Hathaway, for a total value at the time of about $1 million. Since then, the shares have more than doubled, leaving the 11,200 shares worth about $2.2 million at the end of 2017. That switch turned out to be a great move for Girls Inc. of Omaha.

The other winners of the bet: us

Finally, note that Buffett loves to share his investing wisdom with others, offering educational letters to shareholders each year, answering shareholders' questions for many hours during his annual meetings, and welcoming classes of students to Omaha regularly.

This bet is one more way he is teaching us, demonstrating over 10 full years the power of index investing, the value of patience, and the fact that ordinary people choosing ordinary investments can outperform highly compensated Wall Street professionals. Buffett is likely to discuss the bet at his next shareholder meeting in May and in his annual letter to shareholders, which should be released in late February or early March.

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Selena Maranjian owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.