“…it's better for your reputation to fail conventionally than to succeed unconventionally.” – John Maynard Keynes
Back in 2007 Warren Buffett made the following public challenge during his company’s annual meeting in Omaha, Nebraska:
“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”
In response, Ted Seides of Protégé Partners sent a letter to Warren proposing a bet in which Ted would pick a basket of five hedge fund of funds against a low cost, S&P 500 index fund of Buffett’s choice. They eventually agreed on a $1 million purse which would be donated to the charity of the winner’s choice (Girl’s Incorporated of Omaha for Buffett & Ark for Protégé).
Per the terms of the bet, Protégé was able to handpick a basket of five hedge fund of funds to stack up against Buffett’s selection of the Vanguard 500 Index Fund Admiral Shares (VFIAX), which is a mutual fund that tracks the S&P 500 with a 0.05% annual expense ratio. Buffett believed that even though hedge funds are filled with brilliant minds, any potential alpha or outperformance a hedge fund strategy could produce over a passive index approach to investing would be more than gobbled up by the fees being charged by the funds. According to Fortune, Buffett assigned around a 60% chance of winning the bet. Protégé on the other hand, believed that although on average actively managed investments don’t justify their fees, the best of breed active managers in the hedge fund space (e.g. more than just a long-only stock picker) can produce a significant amount of alpha net of all fees and expenses. According to the same Fortune article, Protégé assigned an 85% probability to their chance of winning.
As of the end of last year, we are now eight years into this ten year bet with Buffett firmly in the lead posting a 65.7% return versus Protégé’s five fund of fund average return of just 21.9%. Last year, Ted Seides wrote an article for the CFA Institute which unpacked some of the various reasons why his pony was lagging Buffett’s by such a large margin, and in a separate interview all but conceded the victory barring some sort of major market sell-off. The article actually unpacks why hedge funds have lagged the S&P 500 by significantly more than just the difference in fees (Buffett’s original thesis) since the inception of the Bet, including a mismatch in market exposure (hedge funds aren’t always 100% long stocks) and the zero percent interest rate environment being forced on everyone by central banks around the world.
During the past seven years in the Golden Age of Central Bankers, passive investment strategies tied to US stock indexes, such as the S&P 500, have trounced pretty much every other investable asset class around with minimal volatility. Many are looking at this bet and leveraging Buffett’s reputation as the one of the greatest investors of all time to champion the message that active investing is dead and therefore everyone should simply invest in index funds. Ted Seides understands that pressure better than most. From the same blog post on the CFA Institute’s website:
Public scrutiny of hedge funds tends to focus on the underperformance of traditional asset classes, which was embedded in the Bet. As the argument goes, surely all of these sophisticated alternative strategies have no use when we could have just invested in plain old stocks and bonds and performed better.
So is that it? Should everyone just put their money in index funds tied to the US stock market and forget about it? After all, even Buffett can’t beat his own benchmark as his investment holding company Berkshire Hathaway (BRK/A) also lagged the S&P 500 since the Bet’s inception!
Perhaps there is some wisdom in this sentiment. I can tell you for sure that most investors would be better served putting their money in a low-cost index fund and forgetting about it then by trying to pick the next best stock manager and following their gut when it comes to timing the market. But that being said, it is our human nature to see trends and predict that they will continue into the future. The S&P 500 has been the bell of the proverbial ball the past seven years, but does that mean it will continue to be for the next seven? Risk management in any form (e.g. trend following, diversification, etc.) has been a drag on performance since early 2009, but does that mean it will continue to be for the indefinite future?
Index investing is so hot right now that many investment professionals feel they have no choice but to embrace stocks for the long haul and the fact you can’t time markets because it is often “better for your reputation to fail conventionally than to succeed unconventionally.” Ben Hunt with Salient Partners recently penned a rather in depth investment letter entitled Hobson ’s Choice in which he relates the scene from the movie Five Easy Pieces where Bobby Dupea, played by Jack Nicholson, appears to have a full menu of options to choose from but can’t get something as simple as a side of toast with his omelet to the current lack of choice in the investment landscape. From that same letter, Ben states:
Today we have what appears to be a wide-ranging menu of investment strategies and ideas to choose from. But like Bobby Dupea, our true range of choices turns out to be terribly limited if we show the least preference for something that goes against the grain of conventional wisdom… [T]he more you question the conventional wisdom (not that it's all wrong or a big lie, but simply to inquire whether the conventional wisdom is perhaps less useful in unconventional times, and maybe – just maybe – you might want to have some wheat toast with your omelet) the more you risk getting kicked out of the diner.
As all of our investors and many of our long-time readers know, our investment philosophy does not entirely line up with the conventional wisdom of the buy-and-hold, 60/40 portfolio made up of US stocks and US bonds. That being said, we are huge proponents of low cost investing and allocate the majority of our portfolios to these type of index based exchange traded funds (ETFs). One point where we deviate from the conventional wisdom is in our willingness to accept maverick risk by embracing trend following as an integral part of our risk management program.
Going back to the Bet between Buffett and Protégé, let’s pretend for a moment that a third party (let’s call him Elliott for fun) threw his name in the hat and decided he too would use the same low cost index fund as Buffett, but with one minor tweak. Rather than staying fulling invested 100% of the time over the next 10 years, Elliott wanted to only be invested when the fund’s 50 day moving average was higher than its 200 day moving average. And vice versa, whenever the 50 day moving average was below the 200 day moving average, the fictional investment would sell out of the fund and move to cash by earning the risk free Fed Funds rate. (As a side note, 50 and 200 day moving averages are the most common metrics used to measure mid and long-term trends, so we aren’t cherry picking these numbers).
If Elliott was allowed to enter the bet, he would not only be beating Buffett’s buy-and-hold, passive stock fund eight years in, but he would have done it will much less risk as measured by the volatility of the daily returns and the maximum peak-to-trough drawdown.
All of the alpha for the simple trend following strategy would have come from side-stepping the steep draw down during the 2008-09 Financial Crisis. In fact, between January 1, 2008 and December 31, 2015, the simple 50/200 trend following strategy would have only generated four total roundtrip trades. Of those four trades, only the first would have added value while the other three would have been a drag on performance. This is right in line with what we’ve written in the past on what we call the Babe Ruth Effect.
For firms such as our own that utilize trend following as part of their downside protection process, the past seven years have been frustrating to say the least. Depending on the particular flavor of trend following (e.g. short vs. long-term, moving average vs. channel, etc.), most of the trade signals since the US stock market bottomed in March of 2009 have been head fakes which have been a drag rather than a boost to performance.
Which brings us back to our earlier question. If we project the past seven years into the future, then buy-and-hold, index investing (specifically in US stocks) is the investment strategy every man, woman, and child on earth should pursue. But what if the next seven years look nothing like the past seven? What if the Golden Age of the Central Banker turns into the Bronze Age? What if the US stock market actually lags other stock markets around the world? What if the seemingly unstoppable growth rate in global sovereign debt levels does eventually slow down or stop? What if?
If any of the these scenarios were to play out over the next seven years, would the collective voice of the conventional wisdom be as loud as it is today, and better yet would those buying into this mantra today have the stones to stick to their knitting? History indicates they would not as most investors fancy themselves disciplined, buy-and-hold investors during bull markets only to learn that they are really just emotional, market timers when the you-know-what hits the bear market fan. That being said, buy-and-hold investing is a perfectly valid investment strategy for people with the discipline and conviction of Warren Buffett. But for the rest of us mere mortals, who may fall susceptible to our very human and very real emotions, perhaps there is a better way to invest?
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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