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This is not an official bet. I’m not interested in documenting all the potential details that would be involved, and I don’t have $1 million to wager. Moreover, licensed firms are not allowed to make public fund recommendations, so the details of an official bet would have to be private and that won’t work for my purposes. I’m interested in taking a stand on how investors should think about the investment problem based on core principles like risk parity and factors. This article details how I would think about the problem. While I don’t recommend any specific funds, I do recommend a basic strategy that I am confident will serve investors’ objectives much better than a concentrated investment in stocks over the next decade or so.

History of the Buffett bet

In 2008 Warren Buffett proposed a public bet to show that actively managed investment products, plagued by high fees, would not live up to the goal of beating a passive investment in the Vanguard S&P 500 ETF over the subsequent decade. Only one person had the intellectual conviction to represent the active management side of the bet. Ted Seides at Protégé Partners LLC, a fund-of-hedge-funds firm, placed a $1 million bet that a diversified basket of hedge funds (in fund-of-fund structures) would outperform U.S. stocks from January 1, 2008 through December 31, 2017.

In a letter posted to Bloomberg earlier this year, Seides acknowledged that, with just eight months to go in the bet, “for all intents and purposes, the game is over. I lost.”

But the outcome wasn’t always so certain. Over the first 14 months after Buffett and Seides sealed the wager the S&P 500 lost over half its value. In fact, U.S. stocks lagged Seides’ fund-of-funds portfolio for almost five years before finally pulling ahead in 2014.

Why would anyone bet against Warren Buffett? Seides cited some very good reasons for why he felt such a bet was skewed in his favor at the time. But his primary reasoning was based on market valuations. When Seides agreed to the bet, U.S. stocks were trading at high valuations that had only been observed about 10% of the time over the previous 140 years. That 10% included the months before the Great Depression, and a few years toward the end of the technology bubble in the late 1990s. Both periods subsequently saw stocks produce returns well below their long-term average. Seides felt the historical precedent stacked the odds in his favor.

Of course, Seides’ forecast turned out to be wrong over the bet’s ten-year horizon. U.S. stocks have produced 8% compound returns per year from January 1st, 2008 through September 30, 2017. At last check (May 2017) Seides’ fund-of-funds portfolio had generated less than 3% per year net of fees.

Seides’ rationale for taking the bet was reasonably sound at the time. Markets were very expensive, and history would have guided toward lower future returns. In fact, after enduring one of the worst bear markets in history soon after the bet was struck, it took a run back up to nosebleed levels of valuation at the end of the period to pull Buffett’s side of the bet so far ahead. According to some of the more useful valuation metrics, such as the Shiller CAPE, markets are currently 50%-75% overvalued relative to long-term trend valuations. Moreover, while U.S. markets fully recovered from the epic collapse in 2008 (and more), other major markets were not nearly so fortunate. For example, the Vanguard FTSE All-World ex-US Index fund generated just 1.2% per year over the same horizon.

Figure 1. Vanguard S&P 500 Index fund vs. Vanguard FTSE All-World Index fund total returns, January 1, 2008 – September 30, 2017

Source: ReSolve Asset Management. Data from CSI.

By Adam Butler, read the full article here.