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Warren Buffett's Bet Passive Investing Beats Active Investing

By Floyd Saunders, Founder of Really Simple Investing

In May of 2006, at the Berkshire Hathaway annual meeting, CEO and investor Warren Buffett spoke about the excessive fees charged by hedge fund managers for their claimed expertise in beating the market. In that annual meeting Buffett laid out a bet that the S&P 500 index fund would outperform professional managed hedge funds.

The bet was this: Over a 10-year period commencing January 1, 2008, and ending December 31, 2017, the S&P 500 would outperform a portfolio of five hedge funds of funds, when performance was measured on a basis net of fees, costs and expenses.

If he won, the payout would go to charity.

In July 2007, Ted Seides, a principal at investment firm Protégé Partners, a Wall Street firm that runs funds of hedge funds took the bet. It seems that Mr. Seides made a few claims about the value of investing in a hedge fund like his"

For hedge funds, success can mean outperforming the market in lean times, while underperforming in the best of times,” Seides wrote in his official argument against Buffett’s bet.

Through a cycle, nevertheless, top hedge fund managers have surpassed market returns net of all fees, while assuming less risk as well. We believe such results will continue.” – Ted Seides

Seides expected his hedge fund would have an eighty-five percent chance of winning.

Why Warren Buffett bet on index funds

Buffett, chose the Vanguard Index Fund as a proxy for the S&P 500. Protégé picked five hedge “funds of funds” (whose names have never been publicly disclosed — although Buffett did see their annual audits).

In his 2017 letter to shareholders, Buffett offered a simple equation:

“If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe,

and B is destined to achieve average results before costs, so, too, must A. Whichever group has the

lower costs will win.”

His advice to investors was with Wall Street professionals, charging high fees, it will usually be the fund managers who reap outsized profits, not the clients.

According to Buffett, most professions add value beyond what the average person can do for themselves. But for the most part investment professionals do not do this, despite $140 billion in total annual compensation.

What’s a hedge fund anyway?

Hedge funds are an investment product invented by Wall Street professionals that is only open to “accredited investors”, people with a net worth of at least $1 million, or earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, according to the Securities and Exchange Commission.

Hedge funds can include any pooled investment that is privately organized, administered by professional money managers, and not widely available to the public

With a hedge fund the value of the assets can be managed or “hedged” by purchasing options or the simultaneous use of long positions and short sales on stocks held by the fund. Some hedge funds engage only in 'buy and hold' strategies that do not involve hedging in the traditional sense.

Hedge funds promise investors returns through good times and bad that should exceed market averages. The idea is investors are getting the best and the brightest stock-pickers backed by best research analysts employing the most sophisticated investing tools money can buy.

At the time Buffett made his bet (2007), the typical hedge fund charged a fee of 2% of assets under management and 20% of profits after certain performance thresholds had been met.

By comparison the average mutual fund charges about 0.4% of assets under management with no additional performance threshold fees, according to Morningstar.

Investing in low-cost index funds like the S&P 500 has come to dominate much of investing for good reasons:

  • It’s cheaper than investing in most mutual funds

  • Hedge fund fees are too high, so any outperformance is eroded by the high costs.

  • With an Exchange Traded Fund, there is far less trading (which increases costs)

  • Exchange Traded Funds (ETFs), have tax advantages.

  • Fund managers often do too much trading, which compounds investing mistakes and leads to a higher tax bill.

  • Most trading today is done by professionals who are trading against each other and have little if any advantage over their competition.

Standard & Poor’s has been tracking the record of active managers for more than 20 years. Their mid-year 2022 report indicates that, after five years 84% of large cap actively managed fund managers underperform their benchmark, and after 10 years 90% underperform.

Why low-cost index funds could work for you

Buffett was saying something that had been known to smart investors and traders for some time: Active fund managers have a poor performance record for all of their expected expertise, in part because the excessive fees are a drain on the performance of a hedge fund. A professional manager would have to bet an index fund by the amount of the fees charged and at least match the index. Turns out that is difficult to do over any ten-year period. Turns out that really simple investing with passively managed index funds does really work.

How Did the Bet Go?

In the initial going, the S&P performed horribly. The global financial crisis started in November 2008, leaving the S&P down 45% from its 02007 high. After the first year, Protégé fund of funds did outperform Buffett’s index fund.

But 2008 was a bad year for everyone, Buffett, Vanguard’s Admiral shares—the S&P index fund he’d backed—lost 37% in 2008 vs. a 24% drop, on the average, for Protégé’s five funds of funds.

Buffett gained ground over the next four years, overtaking Protégé in the bet’s fifth year.

And he never looked back. By 02017, it was clear that, short of another collapse in the stock market, Buffett would prevail.

The final scorecard for the bet.

The five “fund of funds” had an average return of only 36.3% net of fees over that ten-year period, while the S&P index fund had a return of 125.8%. Over the decade-long bet, the index fund returned 7.1% compounded annually. Protégé funds returned an average of only 2.2% net of all fees.

Buffett had made his point. For too many investors, fees are often ignored and that is a mistake. With fees subtracted, that money is not re-invested each year with the principal, then a managed fund can almost never overtake an index fund over time.

Seides, thinks Buffett just got lucky, and that the S&P’s performance over the previous decade “vastly over-performed” his expectations.

Wealthy individuals, pension funds, endowments often feel they deserve something ‘extra’ in investment advice and are willing to pay for it. Financial advisors very often get rich from this expectation without doing much for their fees.

When a person with money meets a person with experience, the one with experience ends up with

the money and the one with money leaves with experience.’” – Warren Buffett

If Buffett, who has earned millions for his investors, recognizes the benefits of low-cost index funds, it’s worth making it a part of your core portfolio as well.

Floyd's bio:

Floyd Saunders has more than 35 years of experience in the financial services industry. Floyd’s diverse background includes experience in retail banking, investment banking, insurance, investments, annuities, financial planning, and tax preparation. He has authored the following books: Figuring Out Wall Street, Family Financial Freedom and Five Paths To Wealth.

He has been an adjunct faculty member for Baker University, St. Mary’s College, Moraga, California, and Community Colleges in California, teaching courses in personal money management, managerial finance, money and banking, and principles of banking.

He has worked for Bank of America, JP Morgan and JPMorgan Chase, TransAmerica, Wells Fargo, Citibank, WoltersKluwer/CCH, H.R. Block and as a consultant in the financial services industry. He has prior experience as a registered representative and has published several articles on personal financial planning, investing and personal money management.

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