Ten years ago legendary investor Warren Buffett made a $1 million bet with a hedge fund manager, Ted Seides of New York based Protégé Partners. Mr. Buffett wagered that a group of Mr. Seides’ hedge funds would underperform a low-cost S&P 500 index fund over the next 10 years.

Though the term of the bet does not end until December 31, Mr. Seides has already conceded. As of mid-year the hedge funds had turned in an average return of 2.2 percent per year since 2008 while the S&P 500 fund returned 7 percent per year. To put that in perspective, on $1 million invested in the two alternatives, the index fund would have earned roughly $634,000 more than the hedge fund. Mr. Seides realized that this is a virtually insurmountable lead, and paid the $1 million, which went to charity.

This outcome reinforces our recommendation that investors embrace the efficacy of free markets. Rather than second guess market prices, investors should accept them as the best estimate of value. We do not deny that Wall Street is stocked with brilliant people, nor do we rule out the possibility that some active managers could possess the ability to outperform. But as economists we also realize that anyone who possessed such talent would not give it away for free. It is common for hedge funds to charge their investors annual fees of 2 percent in addition to 20 percent of trading profits — all for the privilege of gambling that they are among the elite few with the magic touch. Meanwhile investors can find S&P 500 funds that charge as little as 0.04 percent or 50 times less than the annual hedge fund levy alone.

Readers might be puzzled that Mr. Buffett would be one to help demonstrate the wisdom of pursuing a simple rules-based approach. After all, his firm, Berkshire Hathaway is hardly well-diversified compared with the overall stock market and Mr. Buffett makes no secret of the fact that his team carefully picks investments that appear to be bargains.

But Berkshire Hathaway is not a mutual fund or an ETF, it is a holding company. As such it often purchases firms outright or takes major positions in them. His success in doing so perhaps speaks more to his skill as a manager rather than as a stock picker. When a firm is identified and added to its holdings, Berkshire Hathaway has authority not afforded mutual fund managers when it comes to making strategic changes intended to add value.

Also In This Issue:
Just the “Equi-facts”
Lessons for the Next Crisis
Back to School
Shorter Settlements
The High Yield Dow Investment Strategy
Recent Market Statistics
The Dow Jones Industrials Ranked by Yield
Recommended Investment Vehicles