In 2008, Warren Buffett issued a challenge to the hedge fund industry, which in his view charged exorbitant fees that the funds' performances couldn't justify. Protégé Partners LLC accepted, and the two parties placed a million-dollar bet. Buffett contended that, including fees, costs and expenses, an S&P 500 index fund would outperform a hand-picked portfolio of hedge funds over the 10 years ending December 31, 2017. The bet pits two basic investing philosophies against each other: passive and active investing.

A Wild Ride

As of February 2017, nine years into the bet, Buffett appears to have taken the right side of the passive-active fight (he may be the quintessential active investor himself, but clearly doesn't think anyone else should try). He said as much in the most recent letter to Berkshire Hathaway Inc. (BRK.A, BRK.B) shareholders, boasting that there was "no doubt" who would come out on top when the contest ends next January.

His victory didn't always seem so certain. Not long after the wager started on January 1, 2008, the market tanked, and the hedge funds were able to show off their strong suit: hedging. Buffett's index fund lost 37.0% of its value, compared to the hedge funds' 23.9%. Buffett then beat Protégé in every year from 2009 through 2014, but it took four years to pull ahead of the hedge funds in terms of cumulative return. (See also, Hedge Fund Fees: Exotic Expenses.)

In 2015, Buffett lagged his hedge fund rival for the first time since 2008, gaining 1.4% versus Protégé's 1.7%. But 2016 saw Buffett gain 11.9% to Protégé's 0.9%. Now the question is whether another downturn could hand the advantage back to Protégé. But time is running out. Altogether, Buffett's index fund bet is up 85.4%, while Protégé's basket of funds – more on that below – is up 22.0%. Given the downturn the market would have to endure this year to close that gap, the hedge fund managers are likely hoping they lose the bet.

In his shareholder letter, Buffett said he believed the hedge fund managers involved in the bet were "honest and intelligent people," but added, "the results for their investors were dismal – really dismal." And he noted that the two-and-twenty fee structure generally adopted by hedge funds (2% management fee plus 20% of profits) means that managers were "showered with compensation" despite, often enough, providing only "esoteric gibberish" in return.

Buffett estimated that the financial "elites" had wasted $100 billion or more over the past decade by refusing to settle for low-cost index funds, but pointed out that the harm was not limited to 1%-ers: state pension plans have invested with hedge funds, and "the resulting shortfalls in their assets will for decades have to be made up by local taxpayers."

Buffet also floated the idea of erecting a statue to the index fund's inventor, Vanguard Group Inc. founder Jack Bogle.

What Exactly Is the Bet?

A few details about Buffett and Protégé's wager. The money Buffett has put down is his own, not Berkshire's or its shareholders'. His chosen vehicle is Vanguard's S&P 500 Admiral fund (VFIAX). Protégé's is the average return of five funds of funds, meaning that the fund-of-fund managers who select the choicest hedge funds themselves take a cut. These funds-of-funds have not been disclosed, in line with SEC rules on hedge funds' marketing.

The million dollars will go to charity: Girls Incorporated of Omaha if Buffett wins, Friends of Absolute Return for Kids if Protégé wins. In an odd twist, the money in the pot, which was supposed to be boring and secure, has seen by far the best return. The sides initially put $640,000 (split evenly) into zero-coupon Treasury bonds that were structured to rise to $1 million over 10 years. But the financial crisis saw interest rates plunge and sent the bonds up to nearly $1 million in 2012.

By mutual agreement, the bettors sold the bonds and bought Berkshire B-shares, which were worth $1.4 million as of mid-February 2015. That 119% return blew both the Vanguard fund and Protégé's funds of funds out of the water, and the stock has continued to outstrip both bets, rising 29.3% over the past 12 months. If the share price drops, the winning charity is guaranteed $1 million anyway, and if the pot remains larger than originally agreed amount, the charity gets the surplus.

The money is being held by the Long Now Foundation in San Francisco, a non-profit which holds parties to long-term bets accountable. To give a sense of how long-term they like to think, the site lists the bet's duration as: "10 years (02008-02017)."

The Tortoise and the Hare

To mere mortals, this may look like a bet between a handful of Masters of the Universe and the world's third-richest person, the Oracle of Omaha. But Buffett has characteristically hit on a humbler metaphor for the wager: Aesop's tortoise and hare. While the hedge funds and funds of funds – the hares – bound around between exotic asset classes and elaborate derivatives, charging high fees for their troubles, passive index investors – the tortoises – worry about other things while the market, significant short-term turbulence aside, gradually gains in value.

Protégé sees things differently, writing before the bet started, "Hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional 'relative-return' investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls" (exactly what happened to Protégé's picks). Protégé argues that "there is a wide gap between the returns of the best hedge funds and the average ones," which justify the fees at the center of the argument. (See also, The Multiple Strategies of Hedge Funds.)

The Bottom Line

Everyone and their mother has an opinion about low-fee, passive index investing versus actively managed investments. The Buffett-Protégé contest provides fodder for arguments on both sides. While Buffett appears set to win according to the terms of the bet, the hedge fund side did show the merits of a bit of extra tweaking and pruning following the 2008 crash, which put them ahead of Buffett's Vanguard fund until 2012. And Protégé did beat the market in the previous cycle: their flagship fund returned 95% from 2002 to 2007, net of fees, versus 64% for the S&P 500. Whatever the final tally turns out to be in the early months of 2018, the active-passive argument will rage on, and some lucky charity will be the real winner.

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