Buffett's bet: Hedge funds can't beat the market

One of the alleged selling points of a hedge fund is that their short-selling makes them outperform during market downturns. So it's a little odd that Buffett stipulated just returns, rather than returns adjusted for some measure of risk (if I had something that returned .5% less than the market on days when market was doing better than average, and .5% more than the market when it did worse than average, this would be a better thing to own than just a market index, even though it gets exactly the same average return -- because it's giving me extra money right when I'd want to buy other things, in exchange for giving me less money at times when I'd prefer to sell).

Interesting that Warrren Buffet should make this bet. He, of all people, should know that extraordinary managers are able to produce extraordinary returns (1.5x to 2x the average?) over time. I think this is reflected in the fact that he only figures he has a 60% chance of winning. It seems he is hanging the bet on the extraordinary fees that hedge funds claim, and hence saying that they would do better over time - just not after the fees.

This is a worthwhile addition to the debate of index funds vs. the best of actively managed funds - most participants in this debate are awfully black-and-white. I have seen several critics practically say that there is no such thing as a better-than-average investor - just a normalized distribution of investor luck.

Hasn't anybody done a survey on this? It shouldn't be too hard to determine with statistics whether the world's top investors are better than or on par with the expected variance in luck. I strongly favor the position that a good investor can beat the market over time..with the caveat that it takes 10 or 20 years to determine who these investors are.

The assessment of fund management suffers from the usual problem - there are bound to be some people who really are just that lucky.

For simplicity if you look at just the last two years and four fund managers, statistically one of them will have won in both years. He will rationalise this away (his 'system') and claim to be a good manager of money.

There are enough funds that quite a few of them are certain to have won in 9 of the last 10 years, further reinforced by the fact that losing funds tend to close.

Because of this effect I would say that past performance is a horrible predictor of future performance. Certainly I am happy to put my money where my mouth is - with the exception of sensible diversification (cash and bonds) my savings are all in low fee index funds.

take a list of 1 million people. tell half that a particular stock will go up and half that a particular stock will go down. discard the 500,000 that you were wrong to and do it again, tell 250,000 that a particular stock will go up and the other half that it will go down. Repeat a few times until you have only a few thousand people left whom think you have been right 7 or 8 times in a row. Tell them you are a stock guru and will teach them your system for $10,000. Profit.

My bet: Buffet and hedge fund managers make lots of money.