The hedge funder Warren Buffett trounced wasn't all wrong. Just mostly

May 05, 2017

A firm update: one of the things I've noticed about the indexing industry is that the researchers who do the studies often are reserved personalities. They tend to enjoy math, they are smart academics, and they get trounced publicly by the active part of the industry. With the intention of repositioning this discussion, this morning One Day In July went on the air with television ads that stretch from the Adirondacks to Mount Washington, from the U.S. border to Rutland, Vermont.

Indexing is the theory with the academic research backing it up, and on average our camp is making the real money, by far. We should not be the ones on defense. It's the active managers and advisors, riddled with conflicts of interest, that need to be explaining why they exist at all.

I'm not playing defense in the ads. :)

10 years ago an active hedge fund manager, Ted Seides, bet Warren Buffett a million dollars (or in Buffett's terms about 1 hour of his earnings), that a group of active hedge funds he selected could beat a passive index Buffett selected. Buffett picked the U.S. S&P 500.

Before getting into the details, note that this was a hard bet for either party to lose. Buffett knew hedge funds as a group are poor investments and don't come close to matching the index, and Seides knew that making a bet against Buffett would put his name in the papers all over the country, and even in the One Day In July newsletter (ok he didn't anticipate that joy), giving him exposure to raise more money for his funds in the future.

With 8 months to go before the deadline and down 85%, Seides is getting beaten so badly he has publicly given up. But his response, published by Bloomberg here, is an interesting read.¹ Most of it is stretched and even journeys into the realm of creative writing, but several points merit discussion.

Seides argues that Buffett happened to pick a very good index over the time period, and in that sense, Buffett got lucky. Given that the S&P 500 is considered the default "index" in almost everyone's mind, I highly doubt Buffett was actively trying to pick the best index. He probably was thinking "I haven't had an ice cream bar from my Dairy Queen business in at least half an hour and I'd like to get back to that, and dealing with this guy represents one hour of my earnings, so I'll just check this box and go with the default."

The important point for us is that even when you are picking a passive index, you are making an active decision. You are always making active decisions as an investor, even if the decision is to pick the default, to leave your money in cash,² or to do nothing.

A second important point is that the assets that one invests in matter most, more than fees or behavior. Had this bet's time period been from 2000 to 2005, Seides might have won, because international markets significantly outperformed the U.S in that time period. Even with the silly stock picking and gi-normous (as my kids would say) fees of hedge funds,³ the international performance in that time window could have dragged him over the finish line with the blue ribbon.

Note that I say "might" have won, because Fortune magazine analyzed his positions in detail,⁴ and he bought hedge fund of funds, which had so many positions they mimicked an index, but one with very high fees. Seides is careful with his wording in that he doesn't say global diversification lost him the bet, just that it dragged down his industry. That gives credence to Buffett's theory that it was just fees that sank Seides. That rhymes.

Seides's own statement, at the end of the day, torpedoes his argument. He says "However unlikely that outcome may have seemed nine years ago, it is the only one that played out." Well, for millions of investors, it wasn't unlikely. It was only unlikely in his mind. It was exactly as likely as the valuation of the S&P 500 implied it was on the day he made the bet. No more, no less. The index was trading at a relatively high level because people all over the world voted, and in aggregate they deemed good performance likely for the future (they were wrong in the short term, and correct in the medium term.)

Dan Cunningham

1. https://www.bloomberg.com/view/articles/2017-05-03/why-i-lost-my-bet-with-warren-buffett
2. Buffett pointed out on CNBC this morning that owning cash as an investment implies you are buying something at 100 times earnings, or about 7 times the average P/E of the S&P 500. Cash pays about 1% right now, so $100 invested makes you $1 / year. I never thought about cash on a Price / Earnings ratio like this, I thought it was quite clever.
3. My kids don't want to invest in hedge funds, not that anyone is asking them to. They don't like fees and they are sticklers for performance. All of their savings is invested in One Day In July indexing models and has been since age 4. Those lemonade stands they are having now, and investing the proceeds of, are going to look mighty good when they are 80.
4. http://fortune.com/2016/05/11/warren-buffett-hedge-fund-bet/