Ten years ago, Warren Buffett challenged any investor to select a fund of hedge funds that would beat the Standard & Poor's 500 index over the next decade. The billionaire investor's aim was to prove anew that money invested passively in an index fund can beat actively managed money, after factoring in fees.
The guy who took him up on the bet conceded defeat this spring. That's a powerful lesson for individual investors.
Buffett wagered with investment manager Ted Seides, who selected a fund of hedge funds. Until year-end 2016, Seides' fund earned an estimated 22 percent after management fees, compared with 85 percent for the S&P 500 index. For Seides, management fees ate up an estimated 60 percent of the gross return.
Not only did the index beat the fund of hedge funds on an after-fee basis, it also thrashed it on a pre-fee basis.
Here are three things to away from Buffett's bet:
1. You don't have to be rich to earn good returns. Everyone who is able to invest has the ability to invest in a low-cost index fund. The expense ratios on exchange-traded funds and mutual funds that track the S&P 500 index are low, and the fees have become even cheaper in recent years, often below 0.1 percent per year.
2. Passive investing can work magic. Part of the secret of Buffett's bet is that he's effectively a passive investor in the index fund, buying at the start of the bet and then holding through the 10 years. He's not actively trading, which has been shown to severely hurt returns. Research shows that passive investing beats 83 percent to 95 percent of active managers in any given year.
3. Continue investing in bad times. Buffett started his bet near a record high point in the market in 2007, right before the economy crumbled and the financial crisis hit. Still, the S&P 500 index handily beat the fund of hedge funds. Now, consider if Buffett had been buying stock as the market fell and adding to his position when stocks were cheap. He would have crushed the professionals merely by adding money at regular intervals.
That strategy wasn't allowed under the terms of the bet, but that doesn't prevent individual investors from using it. That lets you take advantage of the power of dollar-cost averaging, buying into the market at regular intervals and using a market downturn as an opportunity to buy stock more cheaply.
Like this approach? It's easy to get started investing in passive funds like the ones Buffett used and learn how to outsmart high-priced investment managers at a low cost.
James Royal is a writer at NerdWallet. E-mail: jroyal@nerdwallet.com.
