It was announced last week that Berkshire Hathaway will be acquiring a controlling interest in Pilot Flying J. This is Warren Buffett’s second acquisition of a local company after they purchased Clayton Homes in 2003. Buffett has been buying ‘Best in Breed’ companies for longer than I have been alive, and it looks like that tradition has continued with their most recent acquisition of Pilot Flying J. Buffet is always making headlines in the financial press, but a recent story that happened in early September caught my attention. In a 2006 letter to the shareholders of Berkshire Hathaway, Inc., Buffett challenged the hedge fund industry to a $1MM bet that over a ten-year period a basket of hedge funds would under-perform the S&P 500 Index Fund. Buffett’s argument was that due to the high cost structure of the hedge funds (typically 2% fixed fee and 20% of trading profits) that a simple low cost index fund would be able to beat some of the “best and brightest” minds in finance. After all, hedge funds have the ability to trade in markets that mere mortals have never even heard of before. Surely they would be able to beat the S&P 500 Index Fund. Only one brave soul stepped up to the challenge: Protégé Partner’s co-manager, Ted Seides. Seides chose five funds that represented over 100 different hedge funds.
The ten-year period began on January 1st, 2008 and was set to end on December 31st, 2017. But with nearly four months left in the bet, Mr. Seides decided to wave the white flag on the wager and donate the $1MM wager to Mr. Buffett’s charity of choice. The final tally for the period saw the hedge funds returning 2.2% annualized, while the S&P 500 Index fund was nearly three times that at a 7.7% annualized return. Perhaps Mr. Seides decided that he needed a rather large tax write-off this year.
Why should we as investors care about this wager? The most obvious take away is something that our firm places a large emphasis on, which is controlling investment cost. Mr. Seides even noted the hefty fees of the hedge funds were a drag on performance. The other take away is that despite the brightest minds in finance running these firms, they couldn’t manage to beat the “market”. Many investors want to believe that having access to these types of funds will pave the way to great fortune, but the evidence shows that it is a bet at its best.
Focusing on what we can control as investors, especially when it comes to investment costs will serve us better in the long-term rather than searching for “sexy” investments that promise higher than average market returns while extracting large amounts of fees for themselves. While we, as individual investors, may not be able to purchase a controlling interest in successful companies like Buffett, we certainly agree with him that investors should place a greater emphasis on costs when deciding how to allocate their investment dollars.