Being a Boring Investor Can Yield Smart Returns

In 2007, Warren Buffett famously bet $1 million that the broad market would beat the average hedge fund over the next decade. Ted Seides of Protégé Partners LLC stepped up to the challenge. Seides selected a basket of five hedge funds (identity not disclosed) to go head to head with Buffett.

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Despite the vicious market plunge that followed shortly after, Buffett managed to win the bet by a mile.

Nine years down the line, hedge fund portfolios have, on average, climbed 22 percent vs. 85.4 percent by the Vanguard Admiral Shares S&P 500 Index Fund (MUTF:VTSAX), Buffett’s pick.

VTSAX has climbed 15.3% in the year-to-date. It’s managed to notch double-digit returns in 7 out of 9 years since 2009. Buffett says he’s more than willing to put his money on the line again:

”There’s no doubt in my mind that the S&P 500 will do better than the great majority of professional managers achieve for their clients after fees.”

He, however, points out that he will be 97 by the time the wager is decided so he took a pass this time.

Index Funds Beat Out Managed Funds

It sounds like a pretty serious indictment on hedge funds by the Oracle of Omaha. But Buffett is in good company. Investor sentiment regarding actively managed funds has turned overwhelmingly negative since the financial crisis. This is due to a host of issues including chronic underperformance, high fees and quaint strategies.

There’s also the high churn rates: Only half of hedge funds survive over a 10-year span. Hedge funds have delivered poor risk-adjusted returns over the past decade, and investors have been giving them a wide berth. Asset inflows into passive index funds have risen sharply. For example, Vanguard , the grandaddy of passive indexing, has reached total assets of nearly $5 trillion, an all-time high.

Numerous studies have found that index funds steadily beat actively managed funds over the long-term. In fact, one such study found that 86% of actively managed equity funds in the U.S., Europe and emerging markets failed to beat their benchmarks over the past decade.

In another study, Ryan Poirier, senior analyst at S&P Dow Jones, and his collegues established that only 5 percent of mutual funds that invest in large-cap U.S. stocks that beat the S&P 500 in a three-year stretch were able to repeat the feat in the three following years.

Millionaires Love Stodgy Index Funds

There’s a good reason why stodgy index funds outperform their more exotic brethren with alarming alacrity. Index funds typically feature low fees, plenty of diversification and low turnover. They are also able to closely mimic both broad and narrow markets.

There’s an even better reason why 75% of a typical millionaire’s portfolio is held in a mix of public stocks, bonds and cash. (And only 1 in 8 high net worth individuals in the U.S. even owns a hedge fund.) These guys understand the true power of compounding, and how the difference of even a few percentage points in returns net of fees can quickly add up.

Case in point: Look at activist investor Bill Ackman’s Pershing Square Capital letter to shareholders. A respectable gross return of 37.3% in three years was cut nearly in half to 22.2% after fees. Index funds basically free-ride off the research and active monitoring by active funds. Thus, they are able to offer much lower fees. That factor alone can lead to a staggering difference in returns as Warren Buffett’s famous bet aptly proves.

The Case for Hedge Funds

The other factor is that over the long-term, the market tends to allocate capital better than the vast majority of hedge fund managers. And, that rings true even in bear markets where you would be forgiven for thinking that active management should be able to do better than index funds, which slavishly track their benchmark.

The fact is there are some boffo hedge fund managers out there. But there’s simply no sure-fire formula for picking the winners before the event. Only about 2% of fund managers have statistically significant evidence of skill, according to Nobel Laureate Eugene Fama and Kenneth French. Throw in the fact that the law does not obligate hedge funds to publicize their returns, and good luck trying to find a good one.

Still, it would be wrong to adopt a blanket approach and entirely dismiss hedge funds. In a few markets and asset classes, pursuing an active management approach might be worth the trouble. For instance, developing markets tend to be rife with inefficiencies.

Investing in an index fund that covers all emerging markets such as BRICs might turn out to be a mistake due to the unique challenges for each region. Fund managers in such countries tend to be more in touch with local companies than many foreign investors.

Therefore, they might do a better job picking the winners. And some asset classes have shown a clear divergence from the norm for active funds. For instance, 55% of the international small cap funds outperform their benchmarks.

But for the average retail investor, here’s some advice. Do yourself a favor and become a boring investor. Investing in a globally diversified portfolio of low-fee index funds and ETFs that track broad market indices will do you a world of good.

As of this writing, Brian Wu did not hold a position in any of the aforementioned securities.

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