Reference no: EM131984929

Short Story
"The Bet" (or how your money finds its way to Wall Street)

Long Bets was seeded by Amazon's Jeff Bezos and operates as a non-profit organization that administers just what you'd guess: long-term bets. To participate, "proposers" post a proposition at Longbets.org that will be proved right or wrong at a distant date. They then wait for a contrary-minded party to take the other side of the bet.

When a "doubter" steps forward, each side names a charity that will be the beneficiary if its side wins; parks its wager with Long Bets; and posts a short essay defending its position on the Long Bets website. When the bet is concluded, Long Bets pays off the winning charity.

Here are examples of what you will find on Long Bets' very interesting site:

In 2002, entrepreneur Mitch Kapor asserted that "By 2029 no computer - or ‘machine intelligence' - will have passed the Turing Test," which deals with whether a computer can successfully impersonate a human being. Inventor Ray Kurzweil took the opposing view. Each backed up his opinion with $10,000. I don't know who will win this bet, but I will confidently wager that no computer will ever replicate Charlie.

That same year, Craig Mundie of Microsoft asserted that pilotless planes would routinely fly passengers by 2030, while Eric Schmidt of Google argued otherwise. The stakes were $1,000 each. To ease any heartburn Eric might be experiencing from his outsized exposure, I recently offered to take a piece of his action. He promptly laid off $500 with me. (I like his assumption that I'll be around in 2030 to contribute my payment, should we lose.)

Now, to my bet and its history. In Berkshire's 2005 annual report, I argued that active investment management by professionals - in aggregate - would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of "helpers" would leave their clients - again in aggregate - worse off than if the amateurs simply invested in an unmanaged low-cost index fund.

Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds - wildly-popular and high-fee investing vehicles - that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers - who could include their own fund as one of the five - to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?

If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win. (The academic in me requires me to mention that there is a very minor point - not worth detailing - that slightly modifies this formulation.) And if Group A has exorbitant costs, its shortfall will be substantial. There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches.

In my lifetime, though, I've identified - early on - only ten or so professionals that I expected would accomplish this feat. There are no doubt many hundreds of people - perhaps thousands - whom I have never met and whose abilities would equal those of the people I've identified. The job, after all, is not impossible. The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane - a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul - said it well: "In investment management, the progression is from the innovators to the imitators to the swarming incompetents."

Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it's very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet.

But there would remain a difference: The lucky monkey would not find people standing in line to invest with him. Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). Third, most managers will nevertheless seek new money because of their personal equation - namely, the more funds they have under management, the more their fees. These three points are hardly new ground for me: In January 1966, when I was managing $44 million, I wrote my limited partners: "I feel substantially greater size is more likely to harm future results than to help them. This might not be true for my own personal results, but it is likely to be true for your results. Therefore, I intend to admit no additional partners to BPL. I have notified Susie that if we have any more children, it is up to her to find some other partnership for them."

The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial "elites" - wealthy individuals, pension funds, college endowments and the like - have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is -on an expectancy basis - clearly the best choice. My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative.

Much of the financial damage befell pension funds for public employees. Many of these funds are woefully underfunded, in part because they have suffered a double whammy: poor investment performance accompanied by huge fees. The resulting shortfalls in their assets will for decades have to be made up by local taxpayers.

Human behavior won't change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something "extra" in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion may be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: "When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience."

Question:

Summarize Buffett's views on "The Bet" and passive investment management.