“The more I read, the more I acquire, the more certain I am that I know nothing.” ― Voltaire
It’s Blogger Wisdom week here on Abnormal Returns. As we have done in previous editions we asked an esteemed group of finance bloggers a series of (hopefully) provocative questions. The answers are not edited and the author’s name, blog name and Twitter handles follow. We hope you enjoy these posts as much as we do putting them together.
Question: Let’s say Warren Buffett re-ups his famous decade-long bet. (He’s not.) He takes the S&P 500. What would you take (and why)? (Answers in no particular order.)
Given today’s valuation and margin levels, the prospects for the S&P over the next decade don’t seem very good. I wouldn’t be surprised at all if cash did better. So, I’d give the edge to a hedge fund portfolio, but I would want to select ones with low correlations to the equity market, that are true organizations (with characteristics that lend themselves to long-term survivability), and that have not gotten too big in terms of assets so that there are opportunities to be nimble. Also, I would want funds that have fee structures that aren’t typical for those types of entities.
I would go with an index of traditional value stocks, if that is allowed. Values are cheap as can be. If it is the old bet of S&P 500 vs hedge funds, I would still take the S&P 500, as hedge funds are too expensive, and they are too large in aggregate vs the anomalies from which they try to gain advantage.
Private equity has the best shot of beating the S&P in total returns over any given period. However, it would be very close race. The only way that I would bet a million dollars with Warren Buffet is if I had a public-facing fund or product to promote. Betting against the great man may not be anywhere close to a good bet, but it’s good publicity while the bet is ongoing. You could easily grow your business enough to recoup the bet (you will undoubtedly lose) plus a decent profit margin. Great business model!
I’m a fan of simplicity, so give me DFA Global Equity Portfolio (DGEIX). I’m relying on two things Buffett doesn’t seem to believe in: global diversification and factor investing. Even though an index fund tracking the S&P 500 will be cheaper and more tax-efficient – I’m not sure if taxes count in the bet, but they should – ten years gives me a pretty good runway for global exposure to value, size, and profitability to pay off. I’d feel more confident if the bet used a 30-year time horizon, but sign me up for the bet either way.
I did a full article on this here: http://fmdcapital.com/marrying-active-passive-management/
Best pull from the article to satisfy the question is probably this passage:
My personal take is that it IS a high-risk time to be a pure passive investor on a relative and absolute basis. It’s also not exactly confidence-inspiring to see the lackluster hedge fund returns over this bull market or sign on the dotted line for that two and twenty management fee.
Why not find some way to marry the two together and meet in the middle?
My solution would be to commit to using some form of low-cost ETF or index funds for most of your investment accounts. Then divide those assets among accounts or percentages that will be passive and active.
The passive portion should be left to its own devices. Commit to just tuning it out and riding through the ups and downs no matter what. Maybe you visit it once a year just to re-balance a few things and then grind your teeth and move on.
The active side can be a little more nuanced. You don’t have to be some crazy level ten, options-addicted, day-trader. You can still use low-cost ETFs and simply make subtle adjustments as you feel the need to either reign in risk or deploy capital in fresh opportunities. This way you are still minimizing your fees and allowing yourself the flexibility to incrementally shift your asset allocation as needed.
David Shvartsman, Finance Trends, @financetrends, newsletter:
Well, I watched Warren Buffett’s recent CNBC interview and he talked quite a bit about this much-publicized bet. As the bet is structured (choosing between an S&P 500 index fund vs. a “basket of fund of hedge funds”), I’d take the passive investing side nearly every time for a number of reasons, principally the high fee hurdle that stands in the way of fund of hedge funds investors.
With a hedge fund, an investor wants to see meaningful risk-adjusted returns *after* fees, namely the typical “1-2% and 20%” performance fees hedge fund managers take as their compensation. Now with a fund of hedge funds, an extra layer of fees is added on top of that! While I’m not familiar with the exact nature and structure of the fund-of-funds employed in this bet, Buffett’s opponent concurred that high fees were one reason why he lost the bet.
If Warren gets the general index then I’d take just one sector and it would be the technology sector. While tech has done very well over the last several years – I think it’s just getting started when looking out over the next decade as countries like India are now seeing widespread tech adoptions. More of the world is gaining internet access and many tech innovations like autonomous cars and AI are still in their genesis.
Ben Carlson, A Wealth of Common Sense, @awealthofcs, author of Organizational Alpha: How to Add Value in Institutional Asset Management:
The S&P has outperformed any number of foreign markets for a while now. If I had to narrow it down I’d pick emerging markets. While they’ve staged a comeback in 2017, EM underperformed US stocks by around 100% from 2008-2016. So this would be a simple mean reversion play.
Tobias Carlisle, The Acquirer’s Multiple, @greenbackd, co-author of Concentrated Investing: Strategies of the World’s Greatest Concentrated Investors:
Returns to the S&P 500 are likely to be low for the next decade, and accompanied by a lot of interim volatility. The ability to hedge will be a huge advantage. Good long/short hedge funds beat the market gross of fees. Net of fees, it’s closer, but those good hedge funds still win out.
Instead of picking sides, I will describe what it would take for me to be indifferent between the two options. I wrote a blog post about the bet – https://alphaarchitect.com/2017/02/28/dont-bet-against-warren-buffett/. In it, I show that the S&P 500 has about a 60% chance of winning this bet mostly due to the volatility difference between the two investments (S&P has approximately a 15% standard deviation and hedge funds 10%). Therefore, I would be indifferent between the two if 1) hedge funds had a payoff of 1.5 times the bet against the S&P or 2) The bet was a portfolio of 66% S&P 500 and 34% cash (portfolio standard deviation approximately equal to hedge funds) vs. hedge funds with an equal payoff.
If the choice here is between the SPX and hedge funds (or funds of funds) and score is being kept via some index from HFRI then of course the SPX will come out ahead. Most hedge funds/hedge fund strategies are not structured to be equity proxies. Click here to look at the sub-indexes from HFRI. Many of them are not designed to compete with or be proxies for equities.
Like Buffett, I’d bet on an index fund, but I wouldn’t bet solely on the S&P 500. Instead, I would put my money on Vanguard’s Total World Stock ETF (symbol: VT), which charges a svelte 0.11% a year and offers capitalization-weighted exposure to U.S.stocks, developed foreign markets and emerging markets. Over 10 years, you can’t be sure that lower valuations will triumph. But like low costs and broad diversification, low valuations are a key way to stack the odds in your favor–and, today, that would argue for a substantial stake in foreign markets.
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My initial thought was to go with something like emerging market stocks, but I’m going to go with a not-so-obvious answer: reinsurance. My rationale?
– Historically, the Swiss Re Global Cat Bond Index has matched the S&P 500 return since its inception in 2002.
– If we are starting this bet at the beginning of 2018, you’ve got reasonable odds based on today’s valuations that returns for the S&P 500, while still positive, will be lower than average. Meanwhile, you have an asset class in reinsurance that just experienced a brutal year after the most damaging hurricane season since 2005. That bodes well for forward looking expected returns as reinsurance premiums are expected to reset at materially higher levels.
– If and when interest rates ever do rise substantially (LOL), the floating rate nature of these securities should stand to benefit.
– Lastly, the return stream of a diversified basket of insurance-linked securities can be reasonably expected to be uncorrelated with equity market returns, a feature that I would find attractive in making such a bet.
I would take Buffett’s bet on essentially the same terms: a basket of hedge funds vs. the S&P 500. I agree with Buffett that, over the long term, an index fund is likely to crush everything else, particularly after taking tax efficiency and transactions costs into account. But timing does matter, and today the S&P 500 is not priced to deliver positive returns over the next decade. Whether you’re looking at the CAPE, median price/sales ratios or any number of other indicators, they all suggest that the next decade will be disappointing. Even if a basket of market neutral hedge funds earning a mid-single-digit return will likely to beat the S&P 500’s return over the next decade. It’s not that most hedge funds are well managed or worth the cost; most are not. But there have been multiple stretches where market returns were negative or flat over ten years, and we may be in one of those stretches now. In a market like that, you win by not losing.
S&P. It seems hedge funds have actually given up trying to beat the S&P and are now focused on low-vol risk-adjusted returns. I think that’s mostly marketing, but the age where the average hedge fund fashioned themselves as being able to earn 20%+ annual returns seems gone.
This is a more interesting bet now. In the 5 years prior to the 2008 bet the US markets had only compounded at about 9% vs the 13% rate of the last five years. But I’d throw in a caveat. Comparing the nominal returns of the S&P 500 to a hedge fund index over 10 years is stupid. The Protege team should have known better than to take that bet. Given how stable the equity market has been in the last 8 years I’d require that we split the bet into two separate bets. Half the pot goes to the nominal return winner and the other half goes to the risk adjusted return winner based on Sharpe ratio. That way we’re creating a bit more balance with the bet since hedge funds are judged in large part not by how much return they generate but by how they generate it. Interestingly, with low yields, stretched stock valuations and excessive fees in hedge funds I have to admit that neither the hedge fund nor the 100% S&P 500 portfolio looks all that great to me if you’re putting your money where your mouth is….So, if I were making this bet with Buffett – well, over a ten year time horizon I’d feel pretty comfortable taking the S&P 500 with 10% leverage. Over any 10 year period the high probability bet is that the stock market will rise so if you want to beat Buffett then just beat him with a higher beta bet than he has going on. Lame, yes? Smart, Yes.
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Wesley R. Gray, Ph.D., Alpha Architect, @alphaarchitectco-author of Quantitative Momentum: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System:
First, I would never bet against Warren Buffett. Seems like a bad bet based on the evidence I’ve seen.
Second, I still believe in risk/reward, so if this is purely a CAGR competition (not risk-adjusted) I’d take the S&P 500 with a beta = 1 vs. the HF Global index has a beta ~.2.
A portfolio of 7-8 momentum stocks that can be rebalanced frequently will absolutely crush the S&P 500. People forget that the S&P500 is man-made. The index is rebalanced a few times a year and a committee of 12 people decide which stocks stay and which go. I believe individual investors can do a lot better than the S&P 500 without dedicating a lot of time by following a simple trend following system based on price and earnings momentum. A combination of stocks that exhibit the following characteristics is a good start:
Among the top 5% of the best-performing stocks for the past 6 months.
Within 5% of 52-week highs.
A few days to a few weeks of sideways consolidation.
It has received a favorable market response to its most recent earnings report or it belongs to a currently strong industry.
Buying XIV (the inverse short-term VIX ETN) after sizable market corrections can add significantly to your returns, as well.
It’s hard for me to imagine U.S. large cap stocks providing a return close to their ~10% long-term average over the next 10 years given current valuations, but hedge funds are similarly challenged by what is likely to remain a low interest rate environment given they are “cash plus alpha” strategies. If I were forced to choose between the S&P 500 and a group of hedge funds, I’d take the S&P 500 given the higher fee hurdle for hedge fund exposure. I am more confident that a well diversified global portfolio that utilized hedge funds as an alpha source via an overlay will outperform the S&P 500 in both absolute and risk-adjusted terms over the next 10 years.
S&P. There are more Hedge Funds than Dunkin Donuts, Burger Kings and Pizza Huts. There’s much better value in fast food today than most Hedge Funds.
I’d take Betterment customers take-home returns (after tax and behavior gap) versus SP500 take-home returns in a taxable account. The key difference isn’t the difference in allocations, which are quite noisy, but the fact that taxes and behavior gaps will be lower for our clients.
I can’t pony up as much money as Mr. Buffett, but I’d be happy betting an equal share of my wealth. 😉
I wouldn’t bet against Warren Buffett. Being just about the only person in the world to have consistently beaten the market over several decades, no one knows better than Buffett does quite how hard it is to do. That said, although they won’t necessarily beat the S&P 500 Index, I prefer the S&P Global BMI, the MSCI World Index or the FTSE All-World Index, simply for the extra diversification they provide.
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I would take a group of managers with a proven method as well as good results. Eddy Elfenbein and Bill Miller are examples, but there are others. The fees must be modest – no 2 and 20. I would also favor managers who pay attention to risk. There will be another recession in the next ten years. Anything you can do to avoid it will help a lot.
I’d take the S&P. Fama is right despite Thaler getting a Nobel. You can’t beat the market
I would take MSCI ACWI INDEX. This index more accurately represents the returns of the world’s market cap, of which the U.S. is only a relatively small portion (about $18 trillion vs $53 trillion). The MSCI ACWI INDEX is a more representative benchmark of stock market returns which are available for the taking by every investor.
Warren Buffett is not a fool on this one. It sounds like he is picking just a single investment and letting it ride, when in reality he is picking one of the largest (and cheapest), actively managed strategies in the world, exploiting the wisdom of the crowd on the daily basis. And 10 years is not nearly as long as everyone thinks it is: even a strategy with a Sharpe ratio of 0.3 has a near 20% chance of having a negative return over a 10-year period. So clever approaches – e.g. pairing some style-based equity strategies – would still have a not-so-insignificant chance of underperforming.
I think the big key to not losing this bet is not being distracted by alpha. When you look at the HFRI, its beta to the equity market is absurdly low: probably between 0.3 and 0.5. When you consider that the U.S. equity market has been positive in something like 95% of all rolling 10-year periods (with some of the rare exceptions being the Great Depression and the 2000s), you’re really crippling yourself unless your baseline assumption is that the market is going to experience a significant and prolonged contraction in the next decade.
Given that I’m not one for predictions, I’d want to cheat. I’d want to exploit diversification and build a global, multi-asset portfolio and then use leverage to ensure that its equity beta matched that of the S&P 500. I’d be pretty confident in that bet.
Every trade has a numerator and denominator. I would hedge the denominator of Buffett’s trade with a basket of currencies and commodities to not make the trade dependent upon the US dollar and to hedge for possible rising inflation over that period.
I would still take the S&P 500. Fees are obviously an issue but another reason is that it’s basket of five hedge funds. I believe that plain old stock-picking can beat the market, but I don’t trust five managers making macro bets inside a black box to beat the index.
A portfolio of 15-20 stocks that I could select but be forced to hold for the duration of the bet. I think the combination of a relatively concentrated portfolio and patience gives you the best chance of outperforming the market. Patience both reduces the fee advantage of the index fund and limits the risk of you doing something stupid. The downside risks to my bet are two-fold. First, picking a bunch of average companies. After all, time is the enemy of the mediocre business. Second, watching an investment thesis break down – which would almost assuredly happen – and not be able to take any action would be emotionally challenging for my side of the bet.
Thanks to everyone for their time and effort. Stay tuned for a new Blogger Wisdom question tomorrow.