A lot has been written in the past few days about Warren Buffett’s bet with hedge fund firm Protege Partners that the firm couldn’t beat the S&P 500 over 10 years.  We’ve taken an interest in this story because it hits at the heart of the active/passive (alpha/beta) debate.  After reading various media interpretations of the bet and the resulting comments from readers at several websites, we offer the following observations:

1. Buffett is not really against active management.  Think about it.  He is one of the most active long-only managers around.  The result: he beats the market regularly, thus proving active management actually works.
2. His selection of the S&P 500 is curious since a) it is highly constrained vs. hedge funds and b) it is a long-bet, an active bet, in favour of large cap US stocks.
3. Common comparisons to the ”Hare and the Tortoise” parable where the S&P 500 is the tortoise and the hedge funds are the hare are totally backward (as the charts to follow indicate).
4. Even if hedge fund managers have no skill in the long run, they still may exploit “alternative betas” (i.e. risk premia other than large cap US stocks).  So this bet isn’t necessarily about the presence of hedge fund skill as much as it is about new markets and their associated risk premia.  In other words, even if Protege wins, we won’t really know whether it was the result of “skill”.
5. Buffett’s argument that the average active manager produces the market average before fees is valid.  But the average investor can also run a mile in 9 minutes.  Yet many persistently run 7 minute miles.  In capital markets, such persistence is supposed to be arbitraged away by more firms exploiting the same investment strategies, or by more assets flowing to the firms that can exploit them.  Yet non-economic motivations (such as investor inertia, or investment constraints) can conspire to maintain this disequilibrium just long enough for some managers to actually out-perform the average.  (Whether they outperform long enough or by a large enough amount to overcome fees is another question.)
6. Protege Partners is a fund of funds with a so-called “double fee layer” - one for the underlying hedge fund managers and one for Protege itself.  Importantly, as we will see below, Buffett has bet against a group of funds of funds, not a group of (single fee) single managers.
7. According to its website, Protege Partners specializes in emerging hedge fund managers - a group that has been found to offer higher returns than their more seasoned brethren.  So they may not be truly representative of the “average” fund of hedge funds.

So what are Buffett’s odds?  A back-of-the-envelope analysis by AllAboutAlpha.com suggests they’re pretty good.  Over the past 18 years, the HFRI Fund of Funds index has basically kept pace with the S&P 500 (HFRI is after-fees, S&P 500 is total return but before any (minimal) passive management fees).

The 10 year rolling annualized returns (using a geometric average) show that with reinvested dividends, the S&P 500 usually does a little better than the HFRI fund of funds index - although both are on their way down…

The result is that the S&P 500 actually beat the HFRI on a 10-year basis in 86% of months since January 2000 (the first month when the HFRI benchmark had a 10 year history).

So if Protege logs average performance for a fund of funds and both benchmarks perform in a similar manner of the next 10 years as they have in the past 18, then Buffett may emerge the winner.

However, let’s acknowledge the 800 pound gorilla in the room.  The S&P 500 has a volatility only its mother could love.  Since 1990, the average monthly volatility of the S&P 500 has been more than double that of the funds of funds.  Far from being a steady-eddie, Buffett (correctly, although ironically) embraces the wild ride that many used to refer to as “playing the market”.

Another important caveat:  When you stack the S&P total return against the HFRI index of single-manager hedge funds (i.e. not the “double fee layer” funds of funds), the picture reverses itself.  In this scenario, the 10 year S&P 500 return trails that of the hedge funds in 97% of months since January 2000.

So the bottom line is that Buffett has himself a horse race.  And although the outcome may not actually prove the merits of either side, we look forward to the updates from Berkshire annual meetings.

(Editor’s note: As we highlighted in yesterday’s posting about Phil Goldstein, we may only be able to get these reports from Buffett, since as a hedge fund Protege isn’t allowed to talk to the media.)