MarketRiders Blog

My title sounds a little stupid, right? Wrong. Many of our MarketRiders members and investors new to ETFs have been worried about having ETFs with the name “Lehman” in their portfolios, particularly the prolific Lehman 1-3 Year Treasure Bond Funds (SHY) or the Lehman TIPs Bond Fund (TIP). Some investors are confused why these ETFs haven’t gone to $0. In fact, some of them are doing quite well this year.

For the new ETF investor, it’s important to understand that ETFs are created based upon a pre-defined index. An index is defined and maintained by an organization – some of which are more credible than others. For example, Standard and Poors has many equity indices like the S&P 500. The Russell 1000, 2000 and 3000 indexes were developed to track a wider breadth of US stocks and were developed by the Frank Russell Company. Morgan Stanley (MS) runs an enormous indexing businesses.

Indexes are licensed to ETF providers. Lehman Brothers is the world’s largest provider of fixed income indices. This means that Lehman defines what basket of debt securities should go into a particular index.

In fact, in our MarketRiders database, there are 52 fixed income ETFs using Lehman indices. We use many of these Lehman fixed income ETFs in our template portfolios that our members can build and manage themselves. Barclays (BCS) uses it for its iShares products, State Street Bank (STT) for its SPDR products, and MarketVectors also uses Lehman indices.

ETFs are based upon the Lehman indices because the provider of these ETFs has licensed the Lehman index for its fixed income products, in order to construct, manage, and maintain what goes into the ETF.

Lehman decides what to put in the index. For example, if you look at the Bonds inside SHY – you’ll find a basket of US Treasury Notes. SPDR Lehman Municipal Bond contains munis from as far as Missouri to Kentucky to Washington State.

The largest bond ETFs in terms of Net Asset Value with nearly $27 billion invested happen to all be based upon Lehman indices: Lehman 7-10 Year Treasury Bond Fund (IEF), Lehman Aggregate Bond Fund (AGG), Lehman 1-3 Year Treasury Bond Fund (SHY), and Lehman iBoxx $ Invest Grade Corp Bond (LQD).

Here are the 52 indices from the MarketRiders database licensed by Lehman. If you look up any of these symbols, you’ll see little co-relation between Lehman’s fate and the fate of these ETFs. But I would assume that one day soon, Barclays, State Street and MarketVectors will be looking for another way to brand these ETFs.

We all know by now that the House of Representatives rejected HR 3997, the $700 billion, poorly constructed Emergency Economic Stabilization Act of 2008. Let's be clear. This bill was a disaster. Nearly every member of Congress that I heard speak during debate today agreed that the bill was a not what they would like to see, but for some reason concluded that even though it wasn't any good, they should still vote for it.

The fun didn't end there. I heard several members of Congress talk about how mark-to-market accounting rules are causing this mess. Instead of having banks mark a worthless asset to zero; these individuals would rather allow a bank to carry an asset at an artificially high valuation, thereby prolonging this crisis. Marking assets to higher valuations than they're worth does not solve the problem. It merely turns a gaping into a constant wound that will eventually cause the institution to bleed out.

Let's get real. Taxpayers don't like this deal because it bails out Wall Street and will likely not solve the problem. Shifting capital from taxpayers to banks without an actual plan to fix foreclosures and asset valuations is a net wash, not a solution.

I'm going to propose a simple solution that I believe could work:

Instead of providing handouts to bankers, announce that the Federal Government will nationalize any bank unable to meet capital requirements and unable to raise private capital. Like Sweden in the early 90's bleed all private capital from the bank, write down every loan as aggressively as accounting rules allow, and then inject taxpayer capital in exchange for substantial stakes in banks worth saving. Allow other banks to fail, but pass FDIC reform that temporarily guarantees all deposits and transition those deposits to other institutions that the taxpayers now own. With an increase in the FDIC insured limit, depositors can feel confident in putting their money in United States banks once again. Pass legislation that encourages mortgage forbearance or renegotiation for responsible borrowers, thereby stemming the tide of foreclosures. Once markets recover, unlock taxpayer value by taking the nationalized banks public again. This plan in no way bails out Wall Street, gives the taxpayer every advantage, and directly attacks the foreclosure problem.

Today was a bad day for trying to reach consensus on the mortgage bailout thanks to House Republicans trying to remember what fiscal conservatism means. After eight years of writing checks to fund anything and everything the Bush Administration sought, these members of Congress remembered they must stand for re-election on November 4^th. Apparently, they believe that standing behind conservative fiscal ideologies for the next 40 days will keep them in their seats in Washington.

I'm not sure I can blame them for disliking the so-called Paulson Plan. Let's consider the most recent set of facts:

• Are we really going to rely on the same people who led us into this mess to get us out? It is entirely possible that had Fannie Mae and Freddie Mac reform legislation been passed two years ago, the scale of the current economic mess would be greatly reduced.
• I've heard a number of financial experts talking today about how the taxpayers will make money on their $700 billion investment. Here's why I disagree. Investing in bad mortgages is not like investing in distressed companies. If you invest in a distressed company, the company can right itself and provide a good return. If you invest in a second mortgage that was written on a house valued at twice what its currently worth, the odds are slim you will ever see a positive return on that investment.
• Secretary Paulson's plan would entitle him to purchase assets from any financial institution. When asked if this would allow him to purchase from pension plans, he said yes. How does purchasing from a pension plan help the homeowner facing foreclosure or the bank who can't afford to lend any money?
• From what I can tell, the plan does not differentiate between the types of loans that the government can purchase. There is a big difference between purchasing a first mortgage on a property and purchasing a no-documentation loan or home equity line of credit. We may have a chance of recouping money on the first mortgage; we have little to no chance on the others.
• Where are the details? Three pages aren't enough for me to feel comfortable spending this kind of money.

What if we don't do anything at all? What if we let the market sort this out on its own? Isn't this socialism at its worst? As much as I believe in free markets ability to self-regulate, I no longer believe nothing is an option. The United States cannot afford to lose credibility with foreign investors while we're $9.6 trillion in debt. It would be disastrous if foreign countries no longer purchased our debt because they didn't trust the United States financial markets. If we let this linger, retirement investment accounts and pensions could be seriously impaired.

How do we know that a $700 billion bailout will work? Haven't we already pumped hundreds of billions of dollars into the economy? How can we claim that this money is working when the nation's largest thrift, Washington Mutual, just failed tonight? There is no simple answer to this. The fact is nobody knows the right number. It's simply a guess.

So what should happen? Here are some things that I believe are critical when a bailout plan eventually gets finalized.

• Phased approach. There is no reason to spend all the money up front. It makes sense to invest a portion, watch what happens, and evaluate how successful the strategy is.
• Once the government purchases assets, it must be ready to work out these loans to prevent further foreclosures. If we can stem the tide of foreclosures, we can stop this meltdown dead in its tracks.
• Oversight. The Treasury must be accountable for what it purchases. A plan with no or little oversight asks for corruption, preferential treatment to certain institutions, and the like.
• Taxpayers first. This bailout is to protect the taxpayer. Any proceeds from this bailout should go to pay back the money we borrowed and to lower the deficit, not into the pockets of Wall Street bankers who aided in creating this mess.

I wish us all luck in the coming days, and hope that Washington is able to set aside both partisan and Presidential politics in order to put together a plan that has a chance of succeeding in a timely fashion.

The famous professors at Yale have proven that asset allocation accounts for 90% of a portfolio’s return and that stock picking and market timing account for less than 10%.   So what a great time to look at how different asset allocations are faring in this market! 

In 2008 it turns out that asset allocation decisions have everything to do with a portfolio performance. 

On MarketRiders, we use our own ETF portfolio builder to track some “Celebrity Portfolios” including the “Lazy Portfolios” (published by Paul B. Farrell at Marketwatch). These portfolios mimic allocations based upon Yale University’s David Swensen, Dr. William Bernstein, Ted Aronson, and Bill Schulthesis who wrote “The Coffeehouse Investor.” Community members also have posted many interesting portfolios with unique asset allocations that have held up well in the last few months.

These portfolios use ETFs without active management and we track weighted average portfolio fees. The component ETF fees range from .08% to .50% and the weighted average portfolio fees are between .12% and .21%.

Comparing and contrasting portfolios with similar asset allocations, shows a lot about how to build solid “all weather” allocations that have held up even in 2008. While some of the variance is surely explained by the allocation in non-equities (Bonds, Treasury Inflation Protected Bonds and Cash), a lot of it is explained by the level of diversification amongst the other asset classes.

There’s quite a variance between some of the portfolios – even when their equity exposures are similar. Two portfolios each with 60% equity exposure have dramatically different results. 

For example, Bill Schulthesis, a ex-Salomon Smith Barney broker who wrote The Coffeehouse Investor, designed a portfolio with 40% in an intermediate bond index (BND) and 10% in each of 6 stock funds (Vanguad REIT ETF (VNQ), SPDR S&P 500 ETF (SPY), Vanguard Small-Cap ETF (VB), Vanguard Small-Cap Value ETF (VBR), Vanguard Value ETF (VTV), Vanguard FTSE All World ex-US ETF (VEU)). Dr. William Bernstein wrote the "Intelligent Asset Allocator" and "The Four Pillars of Investing" and proposed the same basic allocation. But high exposure to small cap value US stocks and REITs allowed Coffeehouse’s returns to trump Bernstein by over 2 times.

Here are the results as of last night’s close.  These portfolios and the ETFs in them are posted on MarketRiders.

The Best and the Worst Returns

To better understand where the variances lie, we drill down into each asset class to see where returns (or lack thereof) are coming from. Aronson’s portfolio, is the worst so far, down (16.65%) with 80% equity exposure. Unfortunately, Aronson had no REIT exposure and heavy exposure to Emerging Market (VWO) and Foreign Markets (European (VGK) and Pacific (VPL)) which have both been crushed this year. Aronson’s portfolio has performed very well for 5 years on the backs of these asset classes, but 2008 has been his come-uppance. 

The MarketRiders “Low Risk” portfolio is doing the best so far this year – down only (1.83%) – but with 25% exposure to equity and Real Estate (RWR). A strong US allocation (iShares S&P SmallCap 600 Index  (IJR) and SPY) over Foreign Developed and Emerging Markets (VEU) helped dampen the losses.

It's Time to Rebalance!

Today, we’re rebalancing a few of these portfolios where actual allocations now vary greater than 20% off our targets. The most out of balance portfolio is the one built by John Spense and Rick Ferri on MarketWatch. Emerging Markets, Foreign Markets, TIPs and Small Cap US stocks are all out of whack so this portfolio and others will be brought back to their targets. 

Stay tuned.  At the end of the year, we’ll report back and show you how these portfolios did.

Treasury Secretary Paulson and Federal Reserve Chairman Ben Bernanke faced intense scrutiny over their proposed $700B bank bailout today on Capitol Hill (and rightfully so). Let's take a look at the facts:

I believe that everyone, no matter how much investment experience they have, should learn how to take control of their investing, buy a well diversified portfolio of index funds, periodically rebalance their portfolio, and allow their money to compound without fees. So do Warren Buffett (read what he wrote about fees), John Bogle, David Swensen, and other investment industry luminaries. This is because the fees charged by the financial industry, over time, decimate investment returns.

But many people just want investment advice. Most people will spend more time shopping for a car on the weekend to save $1000, than to understand the true cost of the investment advice they are receiving on the nest egg that they're spending their entire working lives building. If you must, here are some tips that I think will help you minimize the damage and give you a shot at having a successful relationship with your stock broker, financial adviser or investment manager.

1. Show Me The Fees. If your financial adviser is charging a fee to oversee your investments, he is probably investing your money in mutual funds that also have fees. Ask for a comprehensive list of all the fees you are paying each year including each fund, its fees, and his fees. Try to get these aggregate fees below 2% per year. My friend has a $6 million account with one of the largest four brokers and to make my point, I calculated his mutual fund fees, loads, and fees to his advisor. Last year he paid about $138,000! He is considering switching to index funds and where he would pay $18,000 per year.

2. Get Invoiced. Most financial advisors "debit" your account either in advance of the quarter or month. Ask them to send you an invoice and write them a check. That way you'll stay aware of the cost for these services.

3. Show Me The Commissions. Ask your adviser to disclose the exact amount of commissions, credits or any form of compensation he or she is paid as an incentive for having you invest in a certain financial product like a mutual fund, annuity, or life insurance product. Also ask for the cost of an index fund alternative so that you can understand exactly what it is costing you to be "sold" a particular product and so that you can justify its price in the future.




4. What's The Tax? The average turnover for a mutual fund is 70% a year. That means nearly all stocks in a portfolio are sold each year and traded for other stocks. Turnover can create taxable income at year end. Each February, after these taxes are known, give your financial advisor your federal and state tax rates and ask him to calculate the taxes generated turnover from your funds. Then sell down these accounts in the amount you need to pay the taxes so you will be able to know the true after tax returns. After all, that's what you keep.

5. Benchmarking -- Compared to What? Many investors are happy when they make money in a fund. But that's how amateurs think. Endowments and elite institutions manage their money managers against a benchmark who, net of fees, should outperform a comparable index fund which charges almost no fees. Have your financial advisor pick a benchmark for each fund and measure your adviser's fund picking skills against how well that fund did against the benchmark. For example, the largest diversified emerging market funds have been up between 25.3% - 35.06% over the last five years. Vanguard's Emerging Markets Stock Index (VEIEX) was up 29.24% including fees of .35%. So if you are happy that you've compounded for 5 years at 25.3% with American Funds New World (NEWFX), you shouldn't be because you lost 4% paying someone trying to beat the market including the 1% you paid in fees.

If your stock broker fashions himself as a stock picker, ask him for a benchmark by which to judge his performance. For example, if he or she is picking large cap US stocks, then buy a token amount of the S&P 500 Index Fund (NYSE:SPY) in the account and measure his yearly returns against the yearly returns of this index.

If the requests I'm suggesting that you make of your adviser or stock broker make you uncomfortable, that's no reason not to make them anyway. These are reasonable ways to hold your advisers accountable. Just think of the discomfort you'll feel if in 15 years, a good chunk of your retirement nest egg has been siphoned away in fees!

The energy debate rages on as oil and gas futures bounce around with 30% corrections. Which side of the energy debate are you on? Bears say that oil and gas prices are coming back down to earth. Speculators and hedge funds bid them up, global demand is slowing and alternative forms of energy will soon replace the fossil fuels we've come to depend upon. Bulls argue that oil and gas supplies are dwindling at the same time that the emerging market economies (China, India, Brazil and 20 others) need more. As their middle class population builds they too will want cars, air conditioning and electricity and demand will increase. Most oil reserves are in countries with unstable governments and when geopolitical events get ugly, prices tend to skyrocket.

I'm a long term energy bull -- 10% of my money has been in energy stocks for the last several years and today I maintain that allocation for two reasons. First, I believe in five years, oil and gas prices will be higher than they are today. Second, owning energy is a great hedge against other asset classes like stocks, the US dollar, and inflation.

No one knows which way energy prices will go next week or month so I continually rebalance my portfolio. As my energy stocks rise, I trim them and when they fall, I add to them. If my portfolio goes to 12% energy, I sell them back down to 10% and vice versa.

Now comes the easiest part – which stocks do I pick? Easy you say? Yes – because I don't worry about stock picking due to a miraculous new invention I'll discuss below. I own three energy stocks: the U.S. Oil & Gas Exploration & Production Index (NYSE:IEO), the U.S. Oil Equipment & Services Index (NYSE:IEZ), and S&P Global Energy (NYSE:IXC). Through these three stocks, I own about 200 energy stocks in precise allocation percentages to parts of the energy sector, weighted according to my own preferences – 60% is in IEO, 30% is in IEZ and 10% is in IXC. Why pick stocks when I can own them all? Here's what I mean.

The 62 stocks in IEO are engaged in the exploration for and extraction, production, refining, and supply of oil and gas products. Through these companies, I own oil wells and acreage where there are natural gas resources. The top 10 holdings of IEO are: Anadarko (NYSE:APC), Apache (NYSE:APA), Chesapeake (NYSE:CHK), Devon (NYSE:DVN), EOG Resources, (NYSE:EOG), Noble (NYSE:NBL), Occidental (NYSE:OXY), Southwestern Energy (NYSE:SWN), Valero, (NYSE:VLO), and XTO (NYSE:XTO).

The 55 stocks in IEZ supply equipment or services to oil fields and offshore platforms (drilling, exploration, engineering, logistics, seismic information services and platform construction). Through these companies, I profit from the high demand to drill more wells, build and service the equipment and pay for services. Because the energy companies are making more money, so do their service providers. This basket includes Baker Hughes Intl (NYSE:BHI), Cameron Intl (NYSE:CAM), Halliburton (NYSE:HAL), Nabors (NYSE:NBR), New Natl Oilwell Varco (NYSE:NOV), Noble (NYSE:NE), Schlumberger (NYSE:SLB), Smith Intl (NYSE:SII), Transocean (NYSE:RIG), and Weatherford (NYSE:WFT).

IXC is a basket of 77 stocks with about half in foreign stocks, including the largest global energy companies that own everything from oil reserves, to refineries to retail distribution. Through IXC, I own British Petroleum (NYSE:BPN), Chevron (NYSE:CVX), ConocoPhilips (NYSE:COP), Exxon Mobil, (NYSE:XOM), Petroleo Brasileiro (NYSE:PBR), Royal Dutch Shell, (NYSE:RDS.A), and Total (NYSE:TOT).

IEO, IEZ and IXC are actually Exchange Traded Funds (ETFs), which are unique index funds. They trade all day on the stock market just like any stock – IBM, Microsoft or Ford. You can buy them at any discount broker for $5 - $10 per trade. And just like any stock, when you sell them, you pay long or short term capital gains.

You probably don't know about ETFs because Wall Street brokers and financial advisors don't want you to because they can't charge you fees on them. Hedge funds, wealthy families and elite institutions use ETFs routinely. They save a fortune over mutual funds because they aren't paying a manager to "beat the market" by selecting the best stocks. Instead, you are paying the ETF provider a fee to run their computer models in order to maintain the stock basket. Its also proven that mutual fund managers rarely beat the market anyway – so why pay their crazy fees?

If you divided up a $10,000 investment in energy into IEO, IEZ, and IXC, you'll pay fees of only $48 per year compared to $150 - $200 if you used similar mutual funds. And you will always do as well as the energy sector averages -- no better, but definitely no worse. On average, mutual fund fees are 6 times greater than ETFs. I also pay less in taxes. That's because buying and selling positions to beat the market generates taxable income. So it's important to look at yearly turnover in a fund. These ETFs have 10% yearly turnover in their holdings versus 70% for the average mutual fund.

You might think that you or some professional money manager will be able to pick stocks and beat these indexes, but it's proven over and over again, that picking stocks and trying to time the market is generally a fool's game. Stock pickers who think they can pick energy stocks consistently over five years and beat the averages after their fees have statistics against them. If you think you can, then you should be wearing a wizard's hat and a magic wand while you're making your investments.

Are you bullish about energy? Then invest with ETFs and leave the stock pickin' to T. Boone Pickens!

Summary:  As for the fees that investors pay in the hedge fund world - and that, of course, is the crux of Buffett's argument - they are both complicated and costly.  A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones "bought" by Buffett in the bet.

The celebrated investor wagers a tidy sum that even carefully chosen hedge funds won't return more than the market over time.

The critic of high investment fees has put his money where his mouth is.

On Protege's side: Seides (right ) initiated the bet, and his partners Bessent (left) and Tarrant joined the action.

(Fortune Magazine) -- Will a collection of hedge funds, carefully selected by experts, return more to investors over the next 10 years than the S&P 500?

That question is now the subject of a bet between Warren Buffett, the CEO of Berkshire Hathaway, and Protégé Partners LLC, a New York City money management firm that runs funds of hedge funds - in other words, a firm whose existence rests on its ability to put its clients' money into the best hedge funds and keep it out of the underperformers.

You can guess which party is taking which side.

Protégé has placed its bet on five funds of hedge funds - specifically, the averaged returns that those vehicles deliver net of all fees, costs, and expenses.

On the other side, Buffett, who has long argued that the fees that such "helpers" as hedge funds and funds of funds command are onerous and to be avoided has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protégé has selected.

We're way past theory here. This bet, being reported for the first time in this article (whose author is both a longtime friend of Buffett's and editor of his chairman's letter in the Berkshire annual report), has been in existence since Jan. 1 of this year.

It's between Buffett (not Berkshire) and Protégé (the firm, not its funds). And there's serious money at stake. Each side put up roughly $320,000. The total funds of about $640,000 were used to buy a zero-coupon Treasury bond that will be worth $1 million at the bet's conclusion.

That $1 million will then go to charity. If Protégé wins, it has asked that the money be given to Absolute Return for Kids (ARK), an international philanthropy based in London. If Buffett wins, the intended recipient is Girls Inc. of Omaha, whose board includes his daughter, Susan Buffett.

And who's holding the money, by way of owning the zero-coupon bond? That's an esoteric institution most readers of this article will never have heard of, the Long Now Foundation, of San Francisco, which exists to encourage long-term thinking and combat what one of its founders, Stewart Brand (of the Whole Earth Catalog), calls the "pathologically short attention span" that seems to afflict the world.

Six years ago the foundation set up a mechanism for - what else? - Long Bets. The foundation receives wagers as donations, oversees the bets until they are decided, and then pays off the winner's designated charity. For this work, the foundation normally gets a $50 fee from each side and then shares fifty-fifty with the charitable winner-to-be in the returns earned on the funds being held. In the Buffett-Protégé bet, however, there will be no such sharing; each side simply made a $20,000 charitable gift to the Long Now Foundation.

To see today's Long Bets listings, go to http://www.longbets.org/. Some bets catalogued there sound as though they were made in sports bars: Actor Ted Danson garnered $2,000 for a charity when the Red Sox won the World Series before a U.S. men's soccer team won the World Cup.

On a more cosmic front, Lotus founder Mitchell Kapor and inventor and futurist Ray Kurzweil have a $20,000 bet on the proposition that "by 2029 no computer - or 'machine intelligence' - will have passed the Turing Test," meaning that a computer won't have successfully impersonated a human. Kapor made that prediction; Kurzweil disagrees with it. Each man, following the rules of Long Bets, has supported his point of view with a brief statement that is posted on the Web site. Buffett's and Protégé's arguments will appear there as well (and are listed here).

Through 2007 the Kapor-Kurzweil bet of $20,000 was the largest on Long Bets. The Buffett-Protégé bet obviously vaults the stakes to the stratosphere. And to that there is a certain history, which began at Berkshire's May 2006 annual meeting.

Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking.

But in July 2007, Ted Seides, a principal of Protégé but speaking for himself at that point, wrote Buffett to say he'd like to make the bet - or at least some version of it.

Months of sporadic negotiation ensued. The two sides eventually agreed that Seides would bet on five funds of funds rather than 10 hedge funds.

Seides, stepping way beyond his usual stakes - say, the cost of a meal - suggested that he and Buffett make the bet for $100,000 (which, he noted, was Buffett's annual salary). Buffett, not knowing then that Long Bets even existed, said that considering his age - he's now 77 - and the complications that a 10-year bet might add to his estate's being settled, he'd only be interested in wagering at least $500,000. Even then, he wrote Seides, "my estate attorney is going to think I'm out of my mind for complicating things."

If $500,000 seemed too steep to Seides, Buffett (for whom it's obviously more of a trifle) had no problem with Seides recruiting partners to help out. And that's what in effect happened, by way of Protégé Partners LLC making the bet rather than Seides.

Protégé, which manages around $3.5 billion, is principally owned by Seides, 37, and two other men, CEO Jeffrey Tarrant, 52, and Scott Bessent, 45. Each has a strong investment background, and two of the three have worked with well-known market practitioners: Seides learned the world of alternative investments under Yale's David Swensen; Bessent worked with both George Soros and short-seller Jim Chanos.

Upon its founding in 2002 by Tarrant and Seides, Protégé set up a fund of funds and began recruiting the kind of sophisticated investors - both institutions and wealthy individuals - who put their money in such funds.

Very aware that the Securities and Exchange Commission prohibits broad-scale marketing by hedge funds and funds of funds, neither Seides nor Tarrant will disclose the precise names of the funds they now run, much less their performance records.

But a London publication, InvestHedge, whose parent runs a hedge fund database, provided Fortune with several years of returns for the firm's flagship U.S. fund, Protégé Partners LP.

From its inception in July 2002 through the end of 2007, the Protégé fund gained 95% (after all fees), soundly beating the Vanguard S&P 500 index fund's 64%.

Protégé's performance was hugely helped by the fact that by mid-2006 the firm was extremely bearish on subprime mortgage securities, including CDOs, and had dispersed its investments in hedge funds to capitalize on that opinion. Most significant, it made an investment in Paulson & Co.'s hedge funds, which under John Paulson made a highly publicized killing in 2007 by short-selling securities linked to subprimes.

All that's history, of course, so let's get back to the bet: Buffett and Seides agreed that they'd periodically disclose where the wager stood. Seides wanted this disclosure to take place whenever the market fell by 10%, because he believes that one of the virtues of hedge funds is their ability to weather tough times. Indeed, in the first quarter of this year, during a down market, Protégé Partners LP fell by only 1.9%, while the Vanguard fund dropped 9.5%.

Buffett insisted, though, that the logical time for disclosure was at Berkshire's annual meeting every spring - and that was the final agreement.

Just how much Buffett will have to say about the bet every year may be limited by one fact: The names of the five funds of funds that Protégé has selected are to be kept confidential. Of course, Buffett knows what the names are, because Protégé must supply him with the audited results of these funds every year. But other than that, the designated funds of funds saw no advantage (at least for now) to declaring their participation in the bet and agreed to go along only if confidentiality was promised. The first fund that Protégé tried to recruit, in fact, wouldn't sign up even then.

Seides and Tarrant do have a few general things to say about the five funds picked. They are equity-oriented (favoring stocks over bonds), tend to invest in hedge funds that avoid in-and-out trading, and are run mostly run by seasoned investment folk rather than tenderfoots.

And we can probably assume that Protégé Partners LP is one of the five, if only because its exclusion would leave the firm with the difficult job of explaining to its investors why the firm didn't care to bet on the success of its own hedge fund choices.

As for the fees that investors pay in the hedge fund world - and that, of course, is the crux of Buffett's argument - they are both complicated and costly.

A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones "bought" by Buffett in the bet.

On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the "helpers" that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

The summation is pretty obvious. For Protégé to win this bet, the five funds of funds it has picked must do much, much better than the S&P.

And maybe they will. Buffett himself assesses his chances of winning at only 60%, which he grants is less of an edge than he usually likes to have.

Protégé figures its own probabilities of winning at a heady 85%. Some people will say, of course, that just by making this bet, Protégé has acquired some priceless publicity.

But then, Protégé clearly wants to win, and it's up against a man who hasn't made a lot of losing bets in his life.

Seides himself sees one strong ray of light: "Fortunately for us, we're betting against the S&P's performance, not Buffett's."

From May 2000 through May 2008, the S&P SmallCap index (IJR) is up over 50% from its competitive index the Russell 2000 (IWM).  Both indices, IJR (S&P 600 SmallCap Index) and IWM (Russell 2000 Index) purport to give an investor exposure to small cap stocks in the US stock market.  The average market caps are similar and many of the same companies exist in each index.  But why does IJR do so much better than IWM?

The ETF industry started with the stodgiest of benchmarks – SPY – the S&P 500.  But today, there are over 700 indexes so the term “benchmark” is now a lot less meaningful.  Friday’s opening of the famous “Russell Trade” got me to take a step back and assess – where are we going with our discussions regarding ETFs on MarketRiders?  Which ETFs are dangerous and why?  Where can an investor get stung, even with ETFs? 

I avoid Russell indices like the plague and so should anyone building an ETF portfolio that they want to hold for a long time.  On www.marketriders.com, we don’t use them in our free template portfolios.  The have tremendous shortcomings, namely the way the indices are constructed.  Why?  The Russell 2000 is rules-based.  Every May 31^st, the smallest 2000 securities in size below the largest 1000 securities, are rank ordered by market capitalizations.  Those that make it each year are kept in and those companies that suffered are booted off.  This creates an enormous turnover rate averaging around 25% each year that creates taxable income for investors. 

Worse yet, the rules-based process for the annual reconstitution, creates another cost for investors.  As David Swensen so aptly described in “Unconventional Success”:

“As the May 31^st date of capitalization ranking nears, sharp-witted arbitrageurs identify those securities most likely to enter or exit… the index.  Knowing that index managers mechanistically buy new joiners and mindlessly sell old exiters, the arbitrageurs buy the stocks likely to enter and sell the stocks likely to leave.  When the July reconstitution occurs, the arbitrage activity causes the index fund manager to pay more for purchases and receive less for sales.”

To illustrate Swensen’s point, I’ve posted a copy of a report on MarketRiders from an investment bank detailing the 2008 “Russell Trade” to illustrate how professional money managers are about to game the system.  For example, 157 stocks are expected to leave the Russell 2000 and 259 will be added.  For money manager who want to use this strategy to make money in the next month, the piece suggests buying small companies with low volume that will be added to the index like Griffin Land and Nurseries (GRIF) or Ames National Corp (ATLO) where the number of shares that index fund and ETF provides will need to buy to rebalance their Russell 2000 products will be equal to hundreds of days of trading volume.  (In fair disclosure, I’m holding Intersections (INTX) just for this “trade” and will sell it on July 1^st)

In contrast, S&P, while its SmallCap index holds many of the same companies, but uses, in Swensen’s words, “a committee-based, moderate-turnover approach to selection stocks.”  In other words – no one knows what the committee will let in and out of the benchmark and when so its impossible to “game.”

In summary -- for a small cap mutual fund manager, the Russell 2000 index is an excellent benchmark.  For the rest of us, investing in it is not the smartest thing to do. 

All of this raises a broader question that I would hope more of us can discuss on MarketRiders:  What defines a superior index?   While its interesting that every company except for Walmart is now issuing new ETFs, I’m hoping we can all explore whether they belong in a portfolio and if so, what kind.  I’d like to know from more of you, what you think is a good index for a permanent ETF portfolio that I would hold for my entire life, and why.

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