When global stock markets closed at the end of 2017, Warren Buffett strode into the winner’s circle to claim more than $2 million for Girls Inc. of Omaha.
In 2007, Buffett wagered that no investment professional could pick a portfolio of at least five hedge funds that would outperform a low-fee S&P 500 index fund over the subsequent decade.
Protégé Partners accepted the challenge. At stake was a donation to a charity of the winner’s choice. By the end of 2016, Buffett’s lead had become so large that Buffett declared victory.1 His opponent conceded. Now it’s official.
I’ve written about the bet before. The bet matters because it illustrates principles that can help you with your clients’ portfolios:
- First, the amount that clients pay to invest determines their share of the rewards from any investment strategy, whether it’s a large-capitalization U.S. stock index fund or a complex hedge fund.
- Second, the reason clients invest is to meet their financial goals.
The bet doesn’t matter, on the other hand, because its measure of success may have nothing to do with their goals. If your clients are saving for retirement, their child’s education, or a home, beating a hedge fund or the S&P 500 isn’t the point objective.
The less clients pay, the more they keep
Investment performance is always time-period dependent. A strategy that works in one ten-year period may not work in the next. In the next ten years, perhaps Protégé Partners’ more diversified mix of asset classes and strategies will prevail. Who knows?
What Buffett made clear, however, is that the less clients pay, the greater their share of the returns produced by any investment. This mathematical reality can be easy to overlook.
Source: Vanguard, using data from Morningstar, Inc., as of December 31, 2017
Consider the table above. Over the ten years of Buffett’s bet, those S&P 500 index funds with expense ratios in the lowest quartile (the bottom one-fourth) returned an annualized 8.37%, almost 99% of the index’s 8.50% return. Those with expense ratios in the highest quartile returned an annualized 7.39%—just 87% of the index’s return.
If your clients’ goals called for an investment in an S&P 500 Index fund, the low-cost options would have given them almost all of the gains, accelerating their progress toward their goals. If their goals called for an allocation to Protégé’s hedge funds, their share of the lower returns would have been more modest.
In early 2017, Buffett wrote, “I estimate that over the nine-year period roughly 60%—gulp!—of all gains achieved by the five funds-of-funds were diverted to the two levels of managers.”1 (The first level was fees charged by the underlying hedge fund managers. The second level was fees levied by the manager who selected these managers.)
If returns are high enough, perhaps 40% of the gains would be enough for your clients. But superior returns are hard to sustain. And your ability to help your clients achieve their goals depends not only on the success of your chosen strategy but also on their share of its returns.
Eyes on the goal
The bet’s prize—a charitable contribution—was a reminder that investing is not simply a battle of wits waged in the capital markets. It’s an undertaking that can improve the lives of your clients and those they wish to help.
As The Wall Street Journal’s Nicole Friedman explained, “The real winner of Warren Buffett’s 10-year bet against hedge funds is Girls Inc. of Omaha.” Girls Inc. will use Buffett’s prize to cover the cost of “transitional housing for 16 young women who are aging out of foster care.”
You can never know which strategy or asset class will outperform over a given period. You can control how much your clients pay. And the greater their share of a given strategy’s returns, the better your ability to help them meet their goals.
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1 Warren Buffett, 2017. Letter to Berkshire shareholders. Retrieved January 8, 2018, at http://berkshirehathaway.com/letters/2016ltr.pdf.