Buffett's Strange Bet

Almost anything Warren Buffett does attracts attention.  A bet for a million dollars certainly qualifies!

Background

For some time, Warren Buffett has expressed skepticism about hedge fund performance beating the broad market averages.  He has frequently offered to bet a million dollars that a basket of ten hedge funds would not beat the market.

Protégé Partners LLC has taken up the challenge.  Carol Loomis, a journalist close to Buffett, broke the story yesterday.  It will take ten years to settle the bet, which involves each side putting up $320,000 to buy zero-coupon treasuries.  The stake, held by a firm specializing in such long-term bets (who knew?!), will be worth a million dollars in ten years.

Mr. Buffett's Unusual Position

Warren Buffett, about whom we have written fondly and frequently, rejects the efficient market hypothesis.  We wrote about his opinions and included some typically colorful quotations in this piece from two years ago.  He famously notes that he would be selling pencils on a street corner if markets were efficient.

In fact, all of us in the investment management business expect to beat the market averages by  a wide margin.  If not, how could we justify charging a fee?

Our Conclusion

Surely Mr. Buffett does not believe that he is the only manager who can beat the market.  He must be doing one of two things.

First, he could be shooting at a very narrow window.  He might agree that others can generate marginal advantages, but not enough to overcome the fees charged by hedge funds.

Second, he could just be generating some publicity and money for some good charities.  After all, he is giving nearly all of his money away anyhow, so why not stimulate more charitable interest.  It is a good way to use his high profile for the greater good.

And Protégé?  We wish the company well. We would take its side of the bet.  In fact, we would make the bet ourselves, but our advertising budget is not big enough!

Comments

[Lisa:]

Protégé Partners LLC is a fund of funds. That means that in addition to the fixed % fee and success fee you pay the underlying hedge funds, there's also a fee layered on top of that by the fund of funds. The article says that Protege charges 1% for its funds of funds. Because the fund of funds might generate positive returns overall even when some of the underlying funds don't, that means that the extra layer of fees generates a significant additional drag.

In other words, Buffett is specifically betting against a fund of funds, because of the double layer of fees.

It would be great if there as a fund of funds ETFs that we could short as a pair trade with SPY.

2008 Jun 10 02:48 AM

[Theoldman59:]

It will be interesting to know the terms of the bet. Since Protege is a fund of funds, one would expect it to average approximately the same gains as the market. The real bet may be in the small print determining what actully constitutes "Beating the market."

Perhaps, Mr. Buffett will let us in on the fine print?

2008 Jun 10 12:23 PM

[Reinko:]

There are many ways to beat broad market indices, here in Holland even pension funds who by law are only allowed to invest in indices can do it.

It is very simple:
In the morning they borrow their stocks to hedge funds and late in the evening they get them back. Of course the hedge funds have to pay a fee for having these stocks for one day.

And at the end of the year the pension fund manager has 'beaten' the index and the pension fund clients are impressed year in year out...
But nothing this pension fund manager has done can't be done by some computer program.

2008 Jun 10 01:06 PM

[zander:]

You are welcome to come to the Long Bets site where you can vote with Protege and or set your own bets up (and they dont have to be $1million)

2008 Jun 10 02:47 PM

[Jeff Miller:]

Zander -- thanks for the explanation about the Long Bets site -- very interesting concept.

Jeff

2008 Jun 11 10:35 AM

[User 985438:]

I think Mr Buffet will easily win the bet. He understands that hedge funds are a sucker's bet, just like so many other "trendy" investments created by supposedly sophisticated people (basket of subprime mortgages, anyone?). With Hedge Funds, you give someone your money to make some high-risk investments. If these investments generate high returns then that someone gets to keep a big part of those returns. If the investments go belly-up, you're out of luck and the "someone" who took your money moves on to the next sucker (I think they call that "opening up a new fund").
I can do the same thing in Las Vegas, have more fun doing it and probably have a better chance of success (but over 10-years I'm very likely to have much less money than when I started).

2008 Jun 11 10:38 PM

[PseudoBrain:]

I think everyone is too focussed on the fees. The fundamental concept remains an issue of diversification. Here you have 5 FoFs which are over diversified, and there you have a S&P which is an equity index, domestic to one country. Question remains, how can one bet on the performance of one or the other?

2008 Jun 12 07:57 AM