Last weekend, Warren Buffett announced that he was retiring. In tribute to the world’s greatest investor, as well as to show how downbeat he has long been on his own profession, we’re publishing an adapted, slightly ‘Alphavillainised’ version of the first chapter of Trillions, Robin’s book on passive investing.
It was a slow, languid summer day in 2007 when Ted Seides settled in behind the desk in his swish corner office on the 15th floor of New York’s MoMA building. CNBC was blaring in the background, but with little else to do, he decided to work through his email inbox. There he spied something intriguing.
A friend had sent him a transcript of a recent meeting between Warren Buffett and a bunch of college students. Seides had long been a fan of the legendary “Oracle of Omaha” and was a devoted attendee of the annual meetings hosted by Buffett’s vast investment conglomerate, Berkshire Hathaway. But something in the transcript made him splutter that morning.
One of the students had asked Buffett about a wager he had offered a year earlier, that an index fund that simply tracked the US stock market would beat any group of high-flying hedge fund managers. Berkshire’s chair noted that no one had dared to take him up on the bet, “so I guess I’m right,” he told the students.
The scorn annoyed Seides, a then thirty-six-year-old Wall Streeter with a passing resemblance to a clean-shaven Judd Apatow. After all, hedge funds were his bread and butter.
He had learned the skill of picking out the finest ones from the master himself, Yale University endowment’s David Swensen. A few years earlier Seides had helped found Protégé Partners, an investment group that specialised in unearthing the industry’s most skilled financial wizards for pension funds and private banks — a “fund-of-hedge-funds.” By 2007, Protégé managed $3.5bn of hedge fund investments on behalf of its clients, and had generated 95 per cent returns, handily beating the returns of the US stock market.
The hedge fund industry first emerged in the 1960s, but had enjoyed explosive growth over the past decade, and by 2007 managed nearly $2tn on behalf of investors around the world. Big hedge fund managers like George Soros and Ken Griffin had amassed vast fortunes, attracting envy even in other well- paid corners of the financial world. By the mid-2000s, most young Wall Streeters dreamt of running a hedge fund, not toiling away in investment banking or — perish the thought — doing unglamorous work such as lending money to companies.
The boom frustrated Buffett, who had long felt that the investment industry overflowed with mediocrities who in practice did little more than line their own pockets with the ample fees they charged clients. At Berkshire Hathaway’s annual meeting in 2006, when he first proposed the wager, he gave the industry both barrels:
If your wife is going to have a baby, you’re going to be better off if you call an obstetrician than if you do it yourself. And if your plumbing pipes are clogged, you’re probably better off calling a plumber. Most professions have value added to them above what the laymen can accomplish themselves. In aggregate, the investment profession does not do that. So you have a huge group of people making — I put the estimate as $140bn a year — that, in aggregate, are and can only accomplish what somebody can do in ten minutes a year by themselves.
Seides was somewhat sympathetic to Buffett’s point that many professional money managers in practice do a poor job, but the proposed bet just looked dumb to him. As CNBC was trumpeting in his office that summer morning, the subprime mortgage crisis had just begun to rumble, and Seides thought that things would get worse before they got better. The hedge fund industry’s freewheeling buccaneers looked like they would be far more adept at navigating the coming storm.
After all, hedge funds can profit from markets moving both up and down, and invest in far more than just the S&P 500 index of US stocks that Buffett had offered up to fight his corner. They may charge plenty, but Seides was confident that they could leap over that hurdle and comfortably beat the S&P 500, which was at the time still trading at exceptionally high valuations, oblivious to the brewing financial crisis.
Seides had missed the 2006 Berkshire Hathaway meeting when Buffett first offered the wager, but since no one had seemed to respond in the interim, and it was a slow day, he started writing an old-fashioned letter to Buffett, proposing to accept his wager. “Dear Warren,” it started:
Last week, I heard about a challenge you issued at your recent Annual Meeting, and I am eager to take you up on the bet. I wholeheartedly agree with your contention that the aggregate returns to investors in hedge funds will get eaten alive by the high fees earned by managers. In fact, were Fred Schwed penning stories today, he likely would title his work “Where Are the Customers’ G5s?”
However, my wager is that you are both generally correct and specifically incorrect. In fact, I am sufficiently comfortable that unusually well managed hedge fund portfolios are superior to market indexes over time that I will spot you a lead by selecting 5 fund of funds rather than 10 hedge funds. You must really be licking your chops!
To his delight, Buffett promptly replied, scrawling a terse message on Seides’s letter and sending it back to his New York office, starting an extended back- and- forth about how to arrange the bet. Eventually, they settled on a million-dollar wager that pitted two diametrically opposed investment philosophies against each other: imperious, expensive investment managers who scour the planet for the most lucrative opportunities, against cheap, passive funds that blindly buy the entire market. It represented reigning wisdom against scrappy underdog.
Despite his renown as an investor, Buffett has long had a jaundiced view of his own profession — something revealed in a little-known but remarkable 1975 letter to Katharine Graham, the former Washington Post owner and grandee of DC society. “If above-average performance is to be their yardstick, the vast majority of investment managers must fail,” Buffett glumly noted.
The main subject of the letter was pensions. With his signature wit, Buffett explained to his glamorous friend the dry actuarial arithmetic of retirement plans that promise to provide members a certain, regular retirement payment. But his most brutal points were on the usefulness of professional fund managers whom pension plans hire to manage their money.
As Buffett laid out with devastating clarity, expectations of above-average performance by all pension funds were “doomed to disappointment.” After all, they in practice were the market. Buffett compared it to someone sitting down at a poker table and declaring, “Well, fellows, if we all play carefully tonight, we all should be able to win a little.”
Add in the trading costs and the cost of paying their salaries, and professionally-managed investment funds would on average inevitably do worse than the broader market.
Of course, many investment groups — and the pension fund executives who entrust them with their money — will counter that the trick is to only invest in above-average managers. Sure, many will be poor, lazy, or wrong, but rigorous research can unearth the stockpicking stars who can consistently beat their market.
This elite would, in the era of laxer regulations, also wine and dine company executives to get discreet but vital market-moving information ahead of the unwashed masses of ordinary investors, and enjoy privileged access to the research of Wall Street firms desperate for their business. Moreover, a lot of trading was still done by individual investors, dentists and lawyers who acted on the recommendation of an army of stockbrokers of often dubious expertise and ethics. In such an environment, the premise that professional fund managers could consistently beat the market surely didn’t seem so unreasonable?
This was certainly the common wisdom at the time. The 1960s saw the emergence of the first superstar mutual fund managers, cerebral stockpickers who became celebrities for their investment acumen.
Up until then, the industry had been dominated by “prudent men in hallowed institutions, quietly tending casks of slowly maturing capital,” as Institutional Investor, an industry magazine, said at the time. But the 1960s bull market — dubbed the “go-go” era — changed everything. “Now the thirst for gains is so great in the fund business that managers are stars, and they get a piece of the profits. Just like Paul Newman and Elizabeth Taylor,” Institutional Investor noted.
These stars aimed to thrash the market, by investing in racy, fast-growing companies like Xerox and Eastman Kodak, many of which were dubbed the “Nifty Fifty” for the zest of their stock market performance. But their lustre dimmed quickly when the boom ended in the late 1960s and the Nifty Fifty fell to earth. In the 1970s bear market — the most brutal since the Great Depression — many would-be investing emperors were shown to be naked.
As Buffett later highlighted in a celebrated 1984 speech, even relying on fund managers with an exemplary track record is often a fallacy. He imagined a national coin-flipping contest of 225 million Americans, all of whom would wager a dollar on guessing the outcome. Each day the losers drop out, and the stakes would then build up for the following morning. Purely as a matter of statistics, after ten days there would be about 220,000 Americans who have correctly predicted ten flips in a row, making them over $1,000.
Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvellous insights they bring to the field of flipping.
If the national coin-flipping championship continued, after another ten days 215 people would statistically have guessed twenty flips in a row, and turned $1 into more than $1mn. And still the net result would remain that $225mn would have been lost and $225mn would have been won.
However, at this stage the successful coin flippers would really begin to buy into their own hype, Buffett predicted:
They will probably write books on ‘How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning,’ Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling sceptical professors with, “if it can’t be done, why are there 215 of us?”
In the conclusion to his letter to the Post’s owner, Buffett therefore laid out his recommendations: Either stay the course with a bunch of big, mainstream professional fund managers and accept that the newspaper’s pension plan would likely do slightly worse than the market; find smaller, specialised investment managers who were more likely to be able to beat the market; or simply build a broad, diversified portfolio of stocks that merely mirrored the entire market.
At the time there were only a handful of such “index funds”, championed by some oddballs working at third-tier, parochial banks in San Francisco, Chicago, and Boston. Many in the industry scoffed at the ludicrous idea that someone should or would lazily settle for whatever the entire stock market did. For the Post, dumping its pension money into such a zany idea certainly proved far too much of a leap. Instead, it entrusted its pension to a handful of fund managers personally recommended by Buffett.
To be fair, his nous helped ensure the newspaper an unusually well-endowed pension fund at a time when many corporate plans are struggling. However, Buffett’s discreet nod to a bunch of innovative funds that merely tried to cheaply mimic the stock market was prescient, and would almost half a century later help him score a victory over Wall Street’s finest minds.
Seides initially proposed to make the bet $100,000 — Buffett’s annual salary — but Buffett wanted to make the stakes more interesting. Given his age and the complications that a decade-long bet might cause for the settlement of his estate in case he passed away, he said he would only be interested in a bet of at least $500,000. Even so, “my estate attorney is going to think I’m out of my mind for complicating things,” he wrote Seides.
That was a bit rich for Seides, so Protégé Partners itself became the counterparty to Buffett’s bet. Each party put up about $320,000, which would be used to buy a zero-coupon Treasury bond that would be worth $1mn at the bet’s conclusion in 2018. If Protégé won, the proceeds would go to Absolute Return for Kids, a charity backed by prominent members of the hedge fund community. If Buffett triumphed the money would go to Girls Inc, a venerable charity that the Buffett family had long supported.
Rather than the 10 hedge funds that Buffett had first proposed back in 2006, Seides selected five funds-of-funds like Protégé Partners itself — investment funds that in turn invest in an array of hedge funds. In total these five funds-of-funds were invested in over a hundred hedge funds. That way, the overall performance would not be distorted by the results of a single awful or awesome money manager. Ever the showman, Buffett insisted that he would announce a tally of how things were going at Berkshire Hathaway’s annual meeting every year.
Due to legal restrictions on gambling in some US states, the bet was arranged through something called Long Bets, a forum for big wagers on the future backed by Amazon’s Jeff Bezos. Although seemingly frivolous, friendly gambles can have a lot of power. In 1600, Johannes Kepler entered into a bet with a Danish astronomer that he could calculate a formula for the solar orbit of Mars in eight days. In the end it took him five years, but the work help revolutionise astronomy.
This was precisely what the Long Bets Project wanted to encourage, and the Buffett- Protégé wager was perfect. It was eventually formally announced in a 2008 Fortune article by Carol Loomis, a well-known journalist and friend of Buffett.
Buffett thought that Protégé’s choosing a bunch of funds-of-funds was a mistake, even if it meant that one bad apple was less likely to spoil the barrel. Hedge funds are expensive, often charging 2 per cent annually of the assets they manage, and taking another 20 per cent cut of any profits they generate. Funds-of-funds put an extra layer of fees on top. In contrast, the S&P 500 index fund that Buffett chose charged just 0.04 per cent a year.
As Buffett argued on the Long Bets website:
A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralising, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.
Seides agreed that traditional mutual fund managers who focus just on stocks will on average underperform a “narrow” benchmark like the S&P 500. But he maintained that it was an apples-to-oranges comparison, given that hedge funds can also profit from falling securities, and invest in a far broader array of markets.
Moreover, while the extra cost was an issue, Seides was confident that funds-of-funds should be able to surmount this by selecting the best hedge funds.
Having the flexibility to invest both long and short, hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional “relative-return” investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls. For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times. Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.
There is a wide gap between the returns of the best hedge funds and the average ones. This differential affords sophisticated institutional investors, among them funds of funds, an opportunity to pick strategies and managers that these investors think will outperform the averages. Funds of funds with the ability to sort the wheat from the chaff will earn returns that amply compensate for the extra layer of fees their clients pay.
Indeed, Buffett initially estimated his chances of winning at a modest 60 per cent, given that his opponent was an “elite crew, loaded with brains, adrenaline and confidence.” Seides, on the other hand, put his chances of besting Berkshire’s chair at a more confident 85 per cent. “Fortunately for us, we’re betting against the S&P’s performance, not Buffett’s,” he said.
Initially, it did look like the Oracle of Omaha would have to eat some humble pie. Buffett declined to discuss the bet at Berkshire’s annual meeting in 2009, when he was trailing well behind. While the hedge funds were down by over 20 per cent in 2008, the index fund chosen by Buffett had lost 37 per cent of its value as the financial crisis rattled markets. It looked like Seides’s argument that hedge funds would do a better job of preserving value in a bear market was bearing fruit.
Things didn’t look much brighter in 2010, when Buffett for the first time discussed the bet at Berkshire’s annual meeting — albeit perfunctorily. The next year he was somewhat more fulsome, but mostly to land a jab at an old target. “The only people that are ahead so far are the investment managers,” he noted, before the shareholder meeting broke for lunch. By year four, the S&P 500 had begun to narrow the difference, but Buffett was still behind.
Given the mounting crisis in Europe at the time, the outcome looked like it rested on a knife’s edge.
In December 2016, Jack Bogle received an enigmatic note from an old friend, a former Morgan Stanley strategist named Steven Galbraith, asking him to block off the first weekend of next May, when Bogle would be turning 88. Galbraith wanted to do something special to celebrate his friend, but refused to tell Bogle what he had cooked up.
Bogle had four decades earlier founded Vanguard, the investment group that brought index-tracking funds to the masses. After an inauspicious start in 1976, Vanguard had, thanks to the messianism of its headstrong founder, become one of the world’s biggest money managers, with an array of dirt-cheap funds that do nothing but attempt to mimic markets rather than beat them. Indeed, it was a Vanguard fund that Buffett had chosen as his champion in his bet with Seides — a bet whose victor would coincidentally be declared around Bogle’s birthday.
As his 88th birthday approached, Bogle had lost his earlier imposing physical presence. His angular features had softened, the severe crew cut he sported for most of his life had become thin and sparse, and his posture had been eroded by scoliosis, age, and other afflictions. Bogle suffered his first of many heart attacks at thirty-one, at age thirty-eight he was diagnosed with a rare heart disease called arrhythmogenic right ventricular dysplasia, and at sixty-seven he finally had a heart transplant. But his voice still boomed like a foghorn, his mind was as sharp as ever, and he had lost none of his appreciation for adventure. So he gamely agreed to whatever mysterious plan Galbraith had hatched.
On the morning of May 5, 2017, Bogle and his family drove from their house in Bryn Mawr to Atlantic Aviation, Philadelphia’s private plane airport. There, a Citation jet with Galbraith picked them up and flew straight to Omaha, for Bogle to attend his first-ever Berkshire Hathaway annual shareholder meeting.
The event is often called the Woodstock of capitalism, a forum for anyone who owns a share in Berkshire Hathaway to ask Buffett and his partner Charlie Munger (who died in 2023) about everything from business to geopolitics and personal values. The duo revel in the attention, Buffett responding with his well-honed folksy wit and Munger with terse acidity.
Checking in at the Omaha Hilton, Bogle received his first awkward but pleasant surprise: A horde of guests armed with iPhones gave Vanguard’s founder the full paparazzi experience, snapping photos of the latest financial celebrity to make a trek to Nebraska’s carnival of capitalism. “It felt like escorting Bono around,” Galbraith recalls. Bogle’s wife, Eve, was a little concerned about the frenzy, given his frailty, but Bogle lapped it up.
The shower of photography continued through the day, including over dinner at the hotel later that evening. “I quickly learned that saying ‘yes’ was infinitely more efficient than saying ‘no’ and then arguing about it,” Bogle later wrote of the experience, in a 2018 book titled The Warren Buffett Shareholder.
It was when he woke up on Saturday morning and looked out the hotel room window that Bogle first realised just how big a deal the Berkshire meeting is. A line four people wide snaked from the conference centre to as far as the eye could see, thousands of people braving the chilly Nebraska morning for the chance to sit closer to Buffett and Munger. That year, about 40,000 people attended, with over half forced to watch a video link from a nearby overflow site. Bogle, his family, and the Galbraiths were, however, given prime seating near the front of the cavernous arena, right behind Berkshire’s longest-standing shareholders and next to its directors.
As usual, the duo opened with a limp joke. “You can tell us apart because he can hear and I can see. That’s why we work so well together,” Buffett wisecracked. He went on with the usual discussion of Berkshire’s last annual results, and as interesting as it was, after a while Bogle began wondering why Galbraith had brought him all the way to Omaha at his advanced age and poor health. But then Buffett made a sudden detour, and all became clear:
There’s one more person that I would like to introduce to you today and I’m quite sure he’s here. I haven’t seen him, but I understood he was coming,” Buffett said, scanning the audience. “I believe that he made it today and that is Jack Bogle . . . Jack Bogle has probably done more for the American investor than any man in the country. Jack, could you stand up? There he is.
To thunderous applause, the gaunt but beaming Bogle, dressed in a dark suit and checkered open-neck shirt, stood up, waved to the crowd, and took a small bow towards Buffett and Munger’s podium.
To attendees who might not know who the old man might be, Buffett explained how index funds like those pioneered by Vanguard had taken on and upended the money management industry.
“I estimate that Jack, at a minimum, has saved and left . . . tens and tens and tens of billions into their pockets, and those numbers are going to be hundreds and hundreds of billions over time,” Buffett said. “So, it’s Jack’s eighty-eighth birthday on Monday, so I just (want to) say, ‘Happy birthday, Jack.’ And thank you on behalf of American investors.” Another round of hearty applause broke out in the arena.
For Bogle, being lauded by Buffett himself in front of thousands of people was an immensely emotional experience. The number of people who wanted a photo with him reached the point where Vanguard’s founder had to start leaving sessions early to give enough time to get out.
Bogle later wrote that he “began to understand why rock stars among our entertainers are so eager to avoid the paparazzi.” Nonetheless, for someone who was near the end of a long and eventful life that had left him wealthy but hardly rich, the sense of an astonishing legacy being recognised and burnished was unmistakable. As Bogle later wrote:
I confess that, on this one grand occasion, I found huge satisfaction in being recognised for my contribution to the world of investing, and to the wealth of the human beings who have entrusted their assets to Vanguard’s index funds. (I’m only human!) . . .
But Buffett is also only human, and Bogle’s visit was akin to a victory lap for the Oracle of Omaha as well.
Just days before the Berkshire’s shareholder meeting, Seides had officially conceded that he had lost the bet. He had left Protégé a couple of years earlier, but on its behalf he admitted that with only eight months of the bet remaining he was doomed to lose.
Commenters on the Long Bets forum were already gloating. “Warren is mopping the floor with Protege,” one said. “No big nailbiter finish here . . . Index funds rule.” In one of the last articles of her remarkable six- decade career at Fortune, Carol Loomis hailed how Buffett “scorches the hedge funds.” Members of Bogleheads, an online forum for fans of Vanguard’s founder, were understandably smug. “The Sage of Omaha proved what Jack and Bogleheads knew all along, passive investing is the way to go,” chortled one of them.
It wasn’t even close. The Vanguard 500 Index Fund — ironically viewed as a dismal failure when launched by Bogle four decades earlier — had returned 126 per cent over the decade. The quintet of funds-of-hedge-funds chosen by Protégé had an average return of only 36 per cent. In fact, not one of the five managed to beat the index fund.
Here’s what the final tally looked like:
In his 2016 annual report, Buffett was not above some gloating:
Bear in mind that every one of the 100-plus managers of the underlying hedge funds had a huge financial incentive to do his or her best. Moreover, the five funds-of-funds managers that Ted selected were similarly incentivised to select the best hedge-fund managers possible because the five were entitled to performance fees based on the results of the underlying funds.
I’m certain that in almost all cases the managers at both levels were honest and intelligent people. But the results for their investors were dismal — really dismal.
Seides agrees with Buffett’s assertion that costs matter greatly, but still thinks that Buffett overplays his message. He argues his mistake was to pit a US stock market fund against a broad array of hedge funds, many of which primarily focus on lower- returning corporate bonds or government debt. Moreover, the decade the bet spanned was an exceptionally good one for US stocks, despite the blow of the financial crisis.
In the end, the proceeds that actually went to Girls Inc. amounted to $2.2mn, thanks to a timely switch of the bet’s collateral from US Treasury bonds into Berkshire stock — highlighting how human discretion can still play a valuable role. The money helped finance a Girls Inc programme for vulnerable young women at a converted convent on the outskirts of Omaha, now appropriately renamed Protégé House.
Naturally, Buffett argues that being a professional investor is not an impossible task, but he is sceptical that many can succeed. Even those who do often see their results atrophy over time. A good record means a fund manager typically attracts a lot of new investors.
But the more money one manages the harder it is to find lucrative opportunities. Since most people in the industry are largely paid according to the amount of money they control, they have little incentive to keep their size manageable. As Buffett has argued:
When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low- cost index funds.
And in case you’re curious, here’s what Protégé House looks like.
From TRILLIONS: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever by Robin Wigglesworth, published by Portfolio, an imprint of Penguin Publishing Group, a division of Penguin Random House, LLC. Copyright (c) 2021 by Robin Wigglesworth.
https://www.ft.com/content/3f449299-318c-4c8f-ab7a-bb3fa7221f9c
