Fortune
Buffett's bet: Hedge funds can't beat the market
Monday June 9, 8:13 am ET
By Carol J. Loomis, senior editor at large


Will a collection of hedge funds, carefully selected by experts, return more to investors over the next 10 years than the S&P 500?

That question is now the subject of a bet between Warren Buffett, the CEO of Berkshire Hathaway, and Protege Partners LLC, a New York City money management firm that runs funds of hedge funds - in other words, a firm whose existence rests on its ability to put its clients' money into the best hedge funds and keep it out of the underperformers.

You can guess which party is taking which side.

Protege has placed its bet on five funds of hedge funds - specifically, the averaged returns that those vehicles deliver net of all fees, costs, and expenses.

On the other side, Buffett, who has long argued that the fees that such "helpers" as hedge funds and funds of funds command are onerous and to be avoided has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protege has selected.

We're way past theory here. This bet, being reported for the first time in this article (whose author is both a longtime friend of Buffett's and editor of his chairman's letter in the Berkshire annual report), has been in existence since Jan. 1 of this year.

It's between Buffett (not Berkshire) and Protege (the firm, not its funds). And there's serious money at stake. Each side put up roughly $320,000. The total funds of about $640,000 were used to buy a zero-coupon Treasury bond that will be worth $1 million at the bet's conclusion.

That $1 million will then go to charity. If Protege wins, it has asked that the money be given to Absolute Return for Kids (ARK), an international philanthropy based in London. If Buffett wins, the intended recipient is Girls Inc. of Omaha, whose board includes his daughter, Susan Buffett.

And who's holding the money, by way of owning the zero-coupon bond? That's an esoteric institution most readers of this article will never have heard of, the Long Now Foundation, of San Francisco, which exists to encourage long-term thinking and combat what one of its founders, Stewart Brand (of the Whole Earth Catalog), calls the "pathologically short attention span" that seems to afflict the world.

Six years ago the foundation set up a mechanism for - what else? - Long Bets. The foundation receives wagers as donations, oversees the bets until they are decided, and then pays off the winner's designated charity. For this work, the foundation normally gets a $50 fee from each side and then shares fifty-fifty with the charitable winner-to-be in the returns earned on the funds being held. In the Buffett-Protégé bet, however, there will be no such sharing; each side simply made a $20,000 charitable gift to the Long Now Foundation.

To see today's Long Bets listings, go to http://www.longbets.org/. Some bets catalogued there sound as though they were made in sports bars: Actor Ted Danson garnered $2,000 for a charity when the Red Sox won the World Series before a U.S. men's soccer team won the World Cup.

On a more cosmic front, Lotus founder Mitchell Kapor and inventor and futurist Ray Kurzweil have a $20,000 bet on the proposition that "by 2029 no computer - or 'machine intelligence' - will have passed the Turing Test," meaning that a computer won't have successfully impersonated a human. Kapor made that prediction; Kurzweil disagrees with it. Each man, following the rules of Long Bets, has supported his point of view with a brief statement that is posted on the Web site. Buffett's and Protege's arguments will appear there as well (and are listed here).

Through 2007 the Kapor-Kurzweil bet of $20,000 was the largest on Long Bets. The Buffett-Protege bet obviously vaults the stakes to the stratosphere. And to that there is a certain history, which began at Berkshire's May 2006 annual meeting.

Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking.

But in July 2007, Ted Seides, a principal of Protege but speaking for himself at that point, wrote Buffett to say he'd like to make the bet - or at least some version of it.

Months of sporadic negotiation ensued. The two sides eventually agreed that Seides would bet on five funds of funds rather than 10 hedge funds.

Seides, stepping way beyond his usual stakes - say, the cost of a meal - suggested that he and Buffett make the bet for $100,000 (which, he noted, was Buffett's annual salary). Buffett, not knowing then that Long Bets even existed, said that considering his age - he's now 77 - and the complications that a 10-year bet might add to his estate's being settled, he'd only be interested in wagering at least $500,000. Even then, he wrote Seides, "my estate attorney is going to think I'm out of my mind for complicating things."

If $500,000 seemed too steep to Seides, Buffett (for whom it's obviously more of a trifle) had no problem with Seides recruiting partners to help out. And that's what in effect happened, by way of Protege Partners LLC making the bet rather than Seides.

Protege, which manages around $3.5 billion, is principally owned by Seides, 37, and two other men, CEO Jeffrey Tarrant, 52, and Scott Bessent, 45. Each has a strong investment background, and two of the three have worked with well-known market practitioners: Seides learned the world of alternative investments under Yale's David Swensen; Bessent worked with both George Soros and short-seller Jim Chanos.

Upon its founding in 2002 by Tarrant and Seides, Protege set up a fund of funds and began recruiting the kind of sophisticated investors - both institutions and wealthy individuals - who put their money in such funds.

Very aware that the Securities and Exchange Commission prohibits broad-scale marketing by hedge funds and funds of funds, neither Seides nor Tarrant will disclose the precise names of the funds they now run, much less their performance records.

But a London publication, InvestHedge, whose parent runs a hedge fund database, provided Fortune with several years of returns for the firm's flagship U.S. fund, Protege Partners LP.

From its inception in July 2002 through the end of 2007, the Protege fund gained 95% (after all fees), soundly beating the Vanguard S&P 500 index fund's 64%.

Protege's performance was hugely helped by the fact that by mid-2006 the firm was extremely bearish on subprime mortgage securities, including CDOs, and had dispersed its investments in hedge funds to capitalize on that opinion. Most significant, it made an investment in Paulson & Co.'s hedge funds, which under John Paulson made a highly publicized killing in 2007 by short-selling securities linked to subprimes.

All that's history, of course, so let's get back to the bet: Buffett and Seides agreed that they'd periodically disclose where the wager stood. Seides wanted this disclosure to take place whenever the market fell by 10%, because he believes that one of the virtues of hedge funds is their ability to weather tough times. Indeed, in the first quarter of this year, during a down market, Protege Partners LP fell by only 1.9%, while the Vanguard fund dropped 9.5%.

Buffett insisted, though, that the logical time for disclosure was at Berkshire's annual meeting every spring - and that was the final agreement.

Just how much Buffett will have to say about the bet every year may be limited by one fact: The names of the five funds of funds that Protege has selected are to be kept confidential. Of course, Buffett knows what the names are, because Protege must supply him with the audited results of these funds every year. But other than that, the designated funds of funds saw no advantage (at least for now) to declaring their participation in the bet and agreed to go along only if confidentiality was promised. The first fund that Protege tried to recruit, in fact, wouldn't sign up even then.

Seides and Tarrant do have a few general things to say about the five funds picked. They are equity-oriented (favoring stocks over bonds), tend to invest in hedge funds that avoid in-and-out trading, and are run mostly run by seasoned investment folk rather than tenderfoots.

And we can probably assume that Protege Partners LP is one of the five, if only because its exclusion would leave the firm with the difficult job of explaining to its investors why the firm didn't care to bet on the success of its own hedge fund choices.

Fees: Big hurdle for Protege

As for the fees that investors pay in the hedge fund world - and that, of course, is the crux of Buffett's argument - they are both complicated and costly.

A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones "bought" by Buffett in the bet.

On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the "helpers" that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

The summation is pretty obvious. For Protege to win this bet, the five funds of funds it has picked must do much, much better than the S&P.

And maybe they will. Buffett himself assesses his chances of winning at only 60%, which he grants is less of an edge than he usually likes to have.

Protege figures its own probabilities of winning at a heady 85%. Some people will say, of course, that just by making this bet, Protege has acquired some priceless publicity.

But then, Protege clearly wants to win, and it's up against a man who hasn't made a lot of losing bets in his life.

Seides himself sees one strong ray of light: "Fortunately for us, we're betting against the S&P's performance, not Buffett's."