How Warren Buffett Won a $1 Million Bet Against the Hedge Fund Industry: What it Means For Investors

In 2007, Warren Buffett made a bold statement about the investment management industry that would lead to one of the most instructive wagers in financial history. His million-dollar bet not only demonstrated the power of simple investment strategies but also exposed fundamental truths about investment costs and market efficiency that remain vital for investors today.

Key Takeaways

• The legendary investor Warren Buffet famously bet $1 million that an S&P 500 index fund would outperform a basket of hedge funds over a 10-year period.
• In 2008, Tom Seides of Protégé Partners accepted the challenge.
• Buffet prevailed, with Seides conceding the bet even before the decade had finished.
• The lesson for the average investor is that low-cost index funds are likely the best long-term option.

The Challenge That Started It All

Buffett’s bet emerged from his long-standing criticism of the high-fee investment management industry. In Berkshire Hathaway Inc.’s (BRK.A) 2005 annual report, he argued that professional active management would underperform simple, passive investing over time.

To prove his point, he publicly wagered $500,000 (later doubled to $1 million) that no investment professional could select at least five hedge funds that would collectively outperform an S&P 500 index fund over 10 years (after fees). Ted Seides of Protégé Partners accepted the challenge, setting up an almost decade-long contest that would begin on January 1, 2008.

The Performance Gap: Index Fund vs. Hedge Funds

The results were strikingly one-sided, so much so that Buffett basically claimed victory a year early. In the nine years from 2008 through 2016, Buffett’s chosen investment, the Vanguard 500 (a low-cost S&P 500 index fund), delivered an average annual return of around 7.1%. In contrast, the hedge fund portfolio selected by Protégé Partners managed only a 2.2% average annual return.

The difference in dollar terms was even more dramatic: a $100,000 investment in the S&P 500 index fund would have grown to about $185,000 in nine years, while the same amount in the hedge funds would have reached only about $121,000.

How Simple Beat Sophisticated

Buffett’s victory wasn’t just about superior returns. It was about the fundamental logic of investing. The hedge funds faced two significant headwinds: high fees and the challenge of consistent outperformance.

While the S&P 500 index fund charged minimal fees (as low as 0.03%), hedge funds typically demand both management fees (around 2% of assets) and performance fees (20% to 50% of any profits). These costs create a substantial hurdle that even skilled managers struggle to overcome.

Moreover, except for 2008, which saw a historic market crash (hedge funds can short the market, while index funds can’t) the S&P 500 outperformed the hedge fund portfolio in every single year of the bet. This is because market efficiency makes it extremely difficult for any active manager to consistently identify and exploit mispriced securities.

Lessons for the Average Investor

The bet’s outcome offers several important lessons for individual investors.

• First, it demonstrates that simplicity often trumps complexity in investing. The straightforward approach of buying and holding a diverse market index consistently outperformed sophisticated trading strategies.
• Second, it highlights the influence of investment costs. Even small differences in fees can compound into significant differences in wealth over time.
• Finally, it suggests that beating the market consistently is extraordinarily difficult, even for highly skilled professionals with vast resources and sophisticated trading strategies.

The Bottom Line

Buffett’s winning bet does more than just prove a point about hedge funds versus index funds. It provides a clear roadmap for individual investors seeking to build wealth over the long term. The victory of the simple index fund strategy suggests that most investors would be better served by focusing on low-cost, broadly diversified investments rather than seeking market-beating returns through expensive, actively managed funds. As Buffett himself concluded, long-term investors will often do best with a low-cost index fund.