> Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore the balance of the universe the active investors must do about average as well.
Am I missing something or is this obviously wrong as a mathematical argument? There could be a group of active investors who do well, a group of passive investors who do poorly, and the average would be in the middle.
Most (all?) passive investors buy index funds which perform about as well as the market but are more robust because of their diversity. I suppose it is possible for a passive investor to put their money in very carefully chosen index funds that perform poorly, but the whole point of passive investing is that you believe that you're unlikely to be able to make those sorts of allocations correctly and consistently.
There certainly are active investors who do very well, but I'm not sure if there are any that significantly beat the market over a long enough time frame.
His argument was that those active investors, minus the fees they charge, won't beat the market over a long timeframe. I agree with him there as well.
But that argument completely ignores the point of the bet: obviously the average of all hedge funds will underperform after fees, almost everyone agrees with that based on simple arithmetic. The real question is whether funds made up of "quality" hedge funds (however that's determined) will outperform or not.
...which crucially depends on whether there's any good way to predict how hedge funds will perform. And that's something that I'm not really sure about - there are absolutely inefficiencies in the market (Buffett made his fortune off of the longer term inefficiencies, so I'm not sure why he's so adamant there are no such systematically exploitable short term ones), and I'm sure some hedge funds profit mightily off of them, but the reality is, too many hedge funds just play "follow the leader" with each other, using strategies that are very similar. These funds exist almost exclusively to collect management fees, not because the fund managers actually have a strategic edge worth pursuing, and for better or worse it's easier to get rich people to put money in a fund if it's similar to the funds that all their rich friends have their money in (niche funds that play unusual strategies tend to have massive trouble finding investors). So there's a huge middle ground of funds that are mostly following some segment of the market, minus fees - if you could figure out which ones are following each other, it might be possible to pick out the competently managed ones that actually have an edge, but I'm not sure.
In any case, this bet is certainly not about average performance of hedge funds vs. average performance of the market, that's pretty much a settled question. Unfortunately there are no details on how this fund of funds is to be selected, so it's hard to comment further.
I agree with Protege that this is an apple to orange comparison. The exact hedge fund is not specified, it could probably invest in anything other than most US large caps represented in S&P500. Heck, it could probably consists of Chinese index funds, which would definitely outperform the S&P if the US spirals into an economic crisis within the 10 years or so.
If the US spirals into an economic crisis, I don't see how China could avoid one. China's economy relies on US demand; if Americans aren't buying Chinese goods, then Chinese factories are closing and Chinese exports will crumble. I don't think anyone knows how to raise non-US or internal Chinese demand for Chinese goods fast enough to compensate for a major shock to the US economy.
The passive investors are, in effect, copying the active investors. They're investing in the sum of what all the active investors are investing in. So they're return is the average of what the active investors are investing in.
A better bet is, "will the hedge fund have a profitable year in which the market overall is down". If you invest in the market as a whole, you need to be prepared to be in for 30+ years, especially with the levels of volatility we have seen in the last 10-20 years.
A hedge fund can make trades that don't depend on the direction of the market, which means you can access your invested capital even in a down year. Buying an index fund doesn't afford you that opportunity -- if you bought the S&P500 index before the whole mortgage meltdown, you would be out a lot of money now. In 30 years, you probably will have made your 10% per year, though.
(One thing to note, though, is that as an average investor, the trades that make hedge funds / investment banks a lot of money are really not available to you. To make any non-directional money these days, you need cheap capital, and nobody's going to give that to you. I know what sorts of trades pay my salary at an investment bank, and if I made them myself, I would lose money. That's the reality.)
Previously, I thought that it was a sure thing for Buffett to win, because I thought portfolio implied maybe 20+ hedge funds, but standing opposite S&P500 are only 5 hedge funds(preapproved by both Buffett and Protege).
Protege has a chance (if i was a betting man, I'd give 1:5 odds they would win).
However, Buffett's bet was smarter, because it also wins if something negative happens to the hedge fund industry as a whole politically and we can see that happening already. Nobody is going to nerf S&P 500.
Also from the article, each side contributed 320k and put the money into zero coupon bonds with maturity in 10 years(ie 640k now -> 1mil in ten years), which will go to winner's charity.
