By David Bassanese

Is it possible for a super cheap and super simple index product to beat the best and brightest investment minds that Wall Street has to offer?

It may seem hard to believe, but that’s exactly what has taken place over the past seven years, thanks to (yet another) cunning bet by the doyen of investment managers, Warren Buffett. It’s a salutary lesson in how high management fees – unless more than made up by superlative investment returns – can drastically eat away at one’s investment returns.

Way back at the start of 2008 – just as the global financial crisis was getting into its stride – Buffett bet a hedge fund “fund of funds” manager that his investment strategy would not beat that of a low cost index fund that merely tracked the S&P 500 index over the following 10-year period.

After Buffett issued the challenge in a speech, one unwitting investment manager - Protégé Partners – took the other side. Each would invest $320,000 in a zero-coupon bond that was estimated to be worth $1 million at maturity. The winner would be allowed give the proceeds to the charity of their choosing.

Sounds easy. Protégé Partners was allowed to invest in any five hedge funds of its choosing, which in turn could invest money anyway they liked. The favoured hedge funds could go defensive or aggressive, investing in any asset market or country in the world – with however much leverage that wanted.

By contrast, Buffett was backing a fund that merely invested in the top 500 US companies, weighted by their market capitalisation.

Seven years into the challenge, the result already seems a foregone conclusion - and the smarty pants hedge fund guru’s aren’t even close. The index fund is up 63.5% after fees, while Protégé’s fancier offering is only up a net 19.6%. The index fund has tripled the return of the gaggle of hedge funds.

To be fair, the hedge funds have not lost in every year. In fact, they won in first year of 2008. But that’s only because they lost 24% of their value during that tumultuous period (hardly a badge of honour), while the index fund was down 37%. Since then, however, the index fund has shown the hedge fund managers a clean pair of heels in each of the last six years, thanks to the ongoing strength of the US equity market. Last year the index fund returned 13.6%, whereas the hedge funds offered up only 5.6%.

Of course, some may argue (including it now seems Protégé) the bet has become unfair because the US equity market has been a global outperformer – meaning a well diversified set of hedge fund strategies would have a hard time beating it. And it’s also argued that hedge funds display their best performance during market downturns, where they are better able to manage downside risks. Come the next great US equity market crash, the hedge funds might reclaim some relative outperformance.

Maybe, maybe not. These hedge funds were free to invest fully in the US market if they wanted to, and with ample leverage if required. They looked elsewhere. The simple fact is that they’ve been unable to beat the world’s largest equity market with a better set of investments. And as for outperforming during downturns, so would a more diversified (and much cheaper) portfolio that includes an element of cash and indexed bond funds.

Higher fees are one reason for the underperformance. After all, the typical hedge fund charges a flat rate of around 2% of funds under management, with around a 20% “outperformance” fee for beating a certain benchmark (such as cash plus 5%). A “fund of funds” manager adds to these costs, by selecting and investing in a range of hedge funds – and charging their own set of management fees over the top, which could be around 1% plus a performance fee of 5%. So total fees for such a “fund of funds” could be around 3% plus a 25% fee for any returns above, say, 5%.

By contrast, Buffett’s preferred index fund charges an annual management fee of only 0.05% (yes the decimal is in the right place).

It means that if the index is able to produce a gross return of 10% a year, the “fund of funds” - assuming a performance benchmark of 5% - would need to produce a gross return of at least 15% a year just to produce the same net (after fee) return.

But even high fees aren’t the whole story. It turns out that before fees, Protégé’s fund has returned 44% over the past seven years – double its net return but still well behind the index fund’s return.

Buffett may have just gotten lucky, but the long-run performance of hedge funds – especially after fees – has been far from great. While there are a few great funds with sound long-run records, the really good ones are quickly closed to new money. And as the weight of money has poured into the industry, a lot of mediocre funds have also been created. On average – as one might expect in a very efficient market – hedge fund performance seems no better than that of a well-diversified portfolio of low cost index funds invested across a range of asset classes.

Proceeds from the bet are destined to go to a girl’s charity in Buffett’s beloved hometown of Omaha. It gets better for the girls – low interest rates led both parties to agree to cash in the zero-coupon bond early and invest the proceeds in Berkshire Hathaway stock, which, according to Fortune Magazine, was worth a cool $US1.6 million back in February. The charity will get the value of that stock or $US1 million in 2018, whichever is greater.