You might’ve heard the name Warren Buffett. He happens to be the 4th wealthiest person in the world at a net worth of $76.9 billion and is the CEO of Berkshire Hathaway. You might not have known, however, that he has a one million dollar bet with the money management firm Protégé Partners. The bet is that an index fund (Buffett’s choice) will out perform an actively managed portfolio of hedge funds (managed by Protégé Partners). Now, why would Warren Buffett, widely regarded as one of the most successful investors in the world, bet against a portfolio managed by a team of active professionals? Before we dive into the answer, I want to explain some differences between the funds.
Index funds are mutual funds that match or closely track a market index. For example, Vanguard’s VFINX is an index fund that matches the S&P 500. So, by purchasing one share, you are purchasing a fractional amount of every company in the S&P 500. Because this is such a simple standard to follow, they are passive investments, so you don’t have to spend your time analyzing, and pretty much becoming a day trader overnight to try to come out ahead. Perhaps the most important aspect of this is that index funds have very low expense ratios (VFINX is 0.14%).
On the other end of the spectrum is actively managed funds. According to Investopedia: Active management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund’s portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell. Now, what this means for you is that you are having to pay someone to make the choices of what to buy, sell, or hold with your money. Also, important to note that the average expense ratio for actively-managed equity mutual funds is 1.2% according to Morningstar, an independent investment research firm.
So, why then did Warren Buffett bet on a passive investment vehicle instead of one with constant scrutiny and the ability to cherry pick the companies to invest in for the most growth. Well, what if I told you that owning tiny portions of 500 companies is more diversified than actively managed funds, therefore subsidizing occasional losses of some companies with gains in others. Another significant factor is that the nominal difference in fees adds up to an astronomical amount over time. And, with those extra fees, the funds have to perform that much better to make up for the drawback in fees. Earlier this year, Fortune did this analysis on how the bet was going. After 9 years, the index fund had a compounded annual increase of 7.1% and the average for the actively managed funds is 2.2%!
Let’s quantify what those tiny numbers in fees add up to when it comes to you and your money. A difference of 1.04% surely can’t amount to much, right? Let’s say you’re a passive investor, and you open an index fund with $10k, and you contribute another $10k a year ($833.33/monthly) with an average of an 8% return for 30 years. At the end of the 30 years, you will have right at $1,198,000 and you will have paid a total of $35,556 in fees over that 30 years. That sounds like a lot paid in fees, but stick with me. On actively managed funds, its also important to note that while the fees are higher, 87% of large capitalization fund managers under performed the S&P 500 Index over the last 5 years, and 82% failed to deliver incremental returns over the last decade. So not only are you getting a lower return on your money, but you are also paying more for that under performance. If we err on the high side for returns and keep the rest of the criteria the same for the first scenario the results are mind boggling. So, lets say you go down to your local financial adviser and open an actively managed account with them at $10k, and you make the same yearly investment of $10k for 30 years and it averages a 6% return over that time (yeah right!). At the end of the 30 years, you’ve got just over $672k and you’ve paid over $175k in fees.
$1,198,000 – $672,000 = $526,000 …..a difference of 44%
What the hell? I thought you were paying these guys to make the right decisions. Surely because they are professionals and they spend 40+ hours a week doing this, they should be able to make the best choices for your financial future.
So, what the “Million Dollar Bet” means for you, is that you should take the advice of potentially the most well known investor ever. And not only is it his advice, he’s put his money where his mouth is with this bet. Admittedly, the bet still isn’t over, but I think it’s a foregone conclusion at this point. The barrier of entry has never been lower with investing, pick a simple index fund and just keep plugging money into it, and in a couple of decades, you’ll be amazed at how much your money has grown.