Warren Buffett Wins $1 Million Bet That Hedge Funds Are a Rip-Off
Billionaire investor Warren Buffett bet that hedge funds were a bad investment. Ten years later, Buffett’s wager proved that hedge funds earn only one third of what a stock index investment does. Economist Bill Black explains the numbers
GREGORY WILPERT: Welcome to The Real News Network. I’m Gregory Wilpert coming to you from Quito, Ecuador. The legendary investor and one of the world’s richest men, Warren Buffett, just won a one million dollar bet. 10 years ago, Buffett placed a bet against the managers of the Hedge Fund, Protégé Partners, saying that an investment in a stock index would outperform an investment in a basket of hedge funds. The bet concluded at the end of 2017 and it was clear that the stock index had outperformed the hedge funds by a factor of 3:1.
To most people who do not invest in stocks or hedge funds, this bet would seem like a frivolous pastime for the super rich. Joining me though, to explore the significance of this bet is Bill Black. Bill is a white collar criminologist, Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is also the author of The Best Way to Rob a Bank is to Own One. Thanks for joining us again, Bill.
BILL BLACK: Thank you.
GREGORY WILPERT: So, first of all, what is your reaction to Warren Buffett winning this one million dollar bet? What is its significance?
BILL BLACK: Well, the significance is how he won the bet and the degree to which he won the bet. Everyone knows about what happens if you’re the CEO of one of the 20 largest banks in the world. You get salary and bonus in the range of 15 million dollars a year. And of course, that is a massive increase and incredibly disproportionate to what workers receive and helps produce inequality.
But the far larger story is about hedge funds and hedge funds, unlike the big banks are not typically publicly traded, so you actually have very little information about them. But very commonly, they pay out far more. Little hedge funds pay out far more in compensation for their CEOs than do the absolute largest banks in the world and this can be by a factor of 10. In other words, there are a number of hedge funds in any given year that may pay the CEO more than 100 million dollars, in fact, well over 100 million dollars in a year.
Right? So, presumably, they must be doing something fantastic to warrant that money that the rest of us couldn’t possibly do and mere top bankers in the world can’t do. And so Buffett’s bet tested that proposition and it found it was all an enormous lie. In fact, if you just invest in what’s called an index fund, and this is a fund that simply buys, in essence, a representative portion of everything in the stock market. It turns out that those kinds of entities have much, much, much lower fees.
And because they have much, much, much lower fees and they do just as well, or better in their investment, you don’t make a little bit more money as an investor if you choose them instead of a hedge fund. You make, as you said in the intro, over three times as much. So, this of course is a crazy area of economics where everything in economic theory says this should never happen but it happens all the time, and continues to happen year after year after year. And so Buffett made the bet not to make money, and by the way, he gave all the proceeds to charity, but to demonstrate how insane the economic world is and how stupid it is to put money with hedge funds who exist basically to be predators against their own clients. So, how…go ahead.
GREGORY WILPERT: Sorry, explain to us briefly what are hedge funds? What do they actually do for those people who aren’t in the know?
BILL BLACK: Okay, so the first key thing to know about hedge funds is that they almost never hedge. So, why are they called hedge funds? Because “hedge” is in finance a word that denotes safety, prudence, to ‘hedge your bet’ is not to make a huge gamble, alright? So, they said, “Let’s call ourselves hedge funds. That’ll sound like we’re really safe.” But they don’t hedge.
What do they do? They do all kinds of different things and what they do varies from time to time because different ideas become hot and people move their money from one hedge fund to the other, and so the other hedge funds respond by, “Oh, okay, if they’re investing a lot in hotels, we’re going to invest a whole lot in hotels.” Hedge funds mostly buy stock positions in things but sometimes they own weird assets like big real estate projects as well.
Sometimes they even take big interests. Some of them now want to take big interests in Bitcoins and things like that. So, they do a bunch of things that are riskier but mostly they do it with huge fees, and again, the story is fees, fees, fees. So, even if they get an otherwise decent return, once you subtract out the fees, they give you a lousy return. Again, you can do three times better by going into index funds. It’s easy to invest in index funds.
Large entities like Vanguard have been doing this for decades. If you do it, you’ll end up with more money and you won’t be subsidizing some of the worst capitalists in the world, the hedge fund CEOs who basically, again, rip off their customers in order to become the wealthiest financial people in the world. But of course, their massive fees and salaries that those fees generate is only the first part of the story.
Hedge funds guys also increasingly run the world. So, why is Donald Trump president? Because a particular hedge fund guy and his daughter decided they were going to make huge investments in Donald Trump. Why? Because this are the same folks, the father-daughter, who funded Breitbart. They’re wackos. They are ultra, ultra, ultra right wing wackos and they got more money than they could ever use. So, why not spend a bunch of it trying to get elected the Trumps of the world with their key advisors being the Breitbarts of the world?
Why not sew hate through the Breitbart network? You’ve got more money than you can possibly use. So, like in the old days, the saying was by the ultra rich, “Money is something you throw off the back of trains.” Well, money is something that you now spend to throw the country under the Trump bus. And you got that much power, even though again, you can’t use all. Even a tiny portion of the money you have, what you really do is hate the government. And if you really hate the government, then what becomes your obsession? Not paying taxes to that evil government.
And so, hedge funds guys, and they are almost exclusively guys, also have the political juice and make the contributions to ensure that they’re huge tax benefits are not taken away, even in the midst of what was supposed to be tax reform. So, between the hedge fund guys and their special tax breaks, and the private equity guys like Bain Capital, Romney and such with their carried interest special tax breaks, they literally pay a lower marginal rate of taxation frequently than do their secretaries.
And to Warren Buffett’s credit, he too, has been talking about this insanity of the tax laws and of course, candidate Trump promised that he would get rid of that obscene tax benefit to the ultra wealthy financial types, and I know it will shock you, but we just passed this huge tax cut bill and it didn’t do away at all with ultra special tax breaks for the wealthiest Wall Street folks.
GREGORY WILPERT: Just to put a name also, to the investor, the hedge fund manager that you were talking about earlier. I mentioned you were talking about Robert Mercer and his daughter, Rebekah Mercer, who funded a large part of Trump’s campaign, is that correct?
BILL BLACK: And created Breitbart and funded many of Breitbart’s efforts.
GREGORY WILPERT: So, the hedge funds apparently receive some kind of special tax breaks as well. But do they serve any kind of socially useful purpose?
BILL BLACK: None. What they do is vacuum up massive amounts of money from the wealthy and give them to even wealthier, and the even wealthier group, of course, is the Mercers of the world.
GREGORY WILPERT: So, what’s the logic behind them receiving any kind of tax breaks? Is there any logic behind it?
BILL BLACK: None that should be called logical.
GREGORY WILPERT: What should ordinary citizens do now? Clearly Buffett won this bet with investing in an index fund. What’s the conclusion to draw from that to invest your money there, or what would you say?
BILL BLACK: Yeah, if you have money and you’re in a position to invest in stocks, that’s how you should do it. It has very low commissions, it doesn’t trade and every time you do a trade you pay fees. So, if you go in yourself and do this, the people that give you the extra special low rates, do everything possible to make sure that you make tons and tons of trades, that you churn. And that’s why overwhelmingly, tiny investors that invest for themselves end up with losing money in record… expansion markets.
So, don’t do that. Don’t wish, “Gosh,” that you could go to a hedge fund, ’cause hedge funds are there to rip you off. Don’t go to brokers who are going to charge you fancy commissions for doing fancier investments. Just go to a fund like, I have no relationship to Vanguard, I don’t make any money. I’m not saying to go to them, they have competitors as well but they’re an example of the type of entity that you can go to that will get you a much better return. For your New Year’s resolutions, folks, do the simple stuff.
Stop paying on obscene interest rates on credit cards. Don’t use your credit cards unless you absolutely have to in a way where you don’t pay them off 100% every month to avoid those kind of interest charges. Put away a rainy day fund. Over 40% of American households can not take an unexpected need for funds of 400 dollars without borrowing or having to sell assets. That means if they get into a minor traffic accident and need to fix their car so they can drive to work, all of their savings will be exhausted and they’ll be forced into predatory lenders.
If you get a little bit more money and you can actually invest in stocks, do it. It’s a much better return on stocks but diversify, diversify, diversify. And that’s what index funds do. They do huge diversification at very tiny costs to you. They don’t churn, so they keep fees very low and if you do that compared to just keeping the money in a mattress or in a savings account, not tomorrow but 10 years from now, you’ll have a lot more money for a down payment to send your kids to school.
GREGORY WILPERT: Of course, I mean, there’s still some risk involved, isn’t there? People invested and lost their pensions in 2008. And of course, especially people who were just about to retire around that time. So, you think the risk is still worth it despite these kinds of possibilities?
BILL BLACK: Yeah, absolutely and indeed, it’s the secret to the massive increase in inequality over the last 7 years. The rich put their money in stocks and while Trump tries to claim that the stock boom started with him, in fact, it started early in Obama and has continued and that has produced a massive increase in wealth. The top 500 wealthiest people in the world added last year nearly a trillion dollars to their wealth. That’s only 500 people. Added nearly a trillion.
You aren’t going to do nothing like that. I’m not going to do nothing like that, but again, over the course of 10 years, 20 years, 30 years, if you can discipline yourself, don’t put it all into stock market, assuredly. Put some in bonds as well, keep some liquid funds so that you deal with life’s emergencies. Create a special savings account if you want to take a super holiday every four years to the Galapagos or something like that, speaking of Ecuador. Put in a big plug for the Galapagos.
All of those things make sense but yeah, you have to take some risk in life financially. Everything’s a financial risk. Putting your money in the mattress is one of the biggest because that money often ends up getting stolen.
GREGORY WILPERT: Okay, well, we’ll leave it there for now. I was speaking to Bill Black, Professor of Economics and Law at University of Missouri-Kansas City. Thanks again for having joined us today, Bill.
BILL BLACK: Thank you.
GREGORY WILPERT: And thank you for joining The Real News Network.