Warren Buffett has made a million dollar bet that the S&P 500 index fund will return more to investors over the next 10 years than a collection of hedge funds that are carefully selected by experts.

The bet was made between Buffett and a company called Protégé Partners LLC – a company that specializes in running funds of funds. Those in the dark – a fund of funds is just like a hedge fund but instead of owning stocks or bonds, it owns other funds.

This has some positive and negative aspects.

The Good

A fund of funds is extremely diversified. Since it consists of funds that each consist of hundreds of stocks it is relatively risk free. This is good during the bad times.

The Bad

When compared to owning stocks or index funds a fund of funds has extremely high fees. Such a fund has an annual management fee of 1% and each one of the funds that it consists of have fees of about 1,5%  a year. In contrast -  owning the Vanguards S&P 500 index fund has a yearly fee of only 0,07%.

Hedge funds also typically collect 20% of the gains they make – this leaves you 80% of which the fund of funds also takes its share – typically about 5%.

Why Buffett Decided to Take This Bet

The high management fees of funds of funds are what Buffett thinks will win him the bet.

In order for a fund or a fund of funds to equal the return of the S&P 500 index, it has to have a lot higher yield than the index. Buffett is essentially saying that even if the fund he is betting against can surpass the yield of S&P 500, the costs associated with the fund will be so high that net of all fees the yield of S&P 500 will be greater than the fund of funds Protégé Partners is running.

You can read Warren Buffett’s and the Protégé Partners views on the bet at Long Bets.

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