$1 Million Dollar Bet

This week CNBC reported that JPMorgan became the seventh bank to cover Buffett’s Berkshire Hathaway, calling it a screaming buy. Its “businesses benefit from best-in-class managements, unmatched balance sheet strength, and many of the companies have strong brands, scale or low-cost competitive advantages,”. “Berkshire’s balance sheet strength is a significant competitive advantage, and its liquidity position is the highest ever,” analyst Sarah DeWitt writes. 

This is not a recommendation to buy or sell Berkshire Hathaway. In full disclosure, Berkshire Hathaway is owned by most of my clients.

In 2007, Buffett made a $1 million wager with Ted Seides who is a hedge fund manager with Protégé Partners. It could be the easiest money Buffett has ever made. Even easier than the millions in interest that he collects every day in the bank. He bet that a low-cost S&P 500 index fund would fare better than a collection of Protégé Partners hedge funds.  This week Ted conceded on his horrible bet early, which was winding up at the end of this year. The $1 million hedge fund investment has reportedly only earned $220,000 in 10 years, while Buffett’s S&P 500 investment returned $854,000. The timing of Ted’s bet couldn’t have been worse. We are now in the second longest bull market in history. If you could own one investment in a bull market, it would be the S&P 500 index fund. A typical hedge fund is constructed to offer downside protection in bear markets. Without World War III, there really was no way that Buffett could lose this $1 million bet. An analogy would be buying term life insurance and never dying. The good news is that you lived, but the bad news, is you lost money. The same could be said of Buffett’s bet. The markets never failed and the insurance was never needed.

The other reason is that the fees alone in a hedge fund are excessive. The typical fees for a hedge fund are 2 and 20. The 2 represents a 2% annual management fee and the 20 represents the 20% cut that the hedge fund gets of profits over a certain return threshold.

Buffett recommends that investors should own the S&P 500, but he didn’t make his billions investing in indexes. This is the one area where he doesn’t take his own advice on investing. He has hired two investment advisors to manage Berkshire’s capital. His managers, Todd Combs and Tedd Weschler, managed their own hedge funds before joining Berkshire. They have been credited for investing in Apple. They now mange over $20 billion in Berkshire capital and it will eventually be all of the money. The reason why Buffett won’t invest in the S&P 500, is he doesn’t want the downside risk of the S&P 500. He made his billions by making bets when the odds were tilted in his favor. The S&P 500 offers 100% upside risk and 100% downside risk. He prefers when the odds are 500% upside risk and 50% downside risk. The better the upside/downside ratio, the bigger his investment.

With markets near all-time highs, the odds of the S&P 500 repeating the same returns over the next 5 years is much less likely to happen. My $1 million bet would be that Todd Combs and Tedd Weschler stand a better chance of outperforming the S&P 500 over the next five years.

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