Codswallop

A rather flawed article by Jared Dillian from Bloomberg poses the question Does Warren Buffett Not Understand Risk-Adjusted Returns? 

It has all the makings of a smoke and mirrors attempt to cast doubt over Warren Buffett's simply stated opinion that:

A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.

I'm sure that Warren Buffett understands all too well that risk and returns are related, but the precise terms of the bet chosen by Warren Buffett to highlight his his view was this:

Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender.

There are thousands of indexes, covering a range of risk levels, so while comparing the returns from a stock index tracking fund against a bond index tracking fund would be meaningless, so is throwing into the debate the suggestion that the degree of risk somehow diminishes Warren Buffett's notion. 

Back to his bet, and so what if the Sharpe Ratio for ONE of the five "funds of funds" had a "superior" score? 

And if you calculate their Sharpe ratios and compare them with the S&P 500, fund C is actually superior to the index. If I were a shareholder of fund C, I would be pretty happy in spite of the under-performance, because I received a better return per unit of risk. In terms of professional money management, that is what you pay for. That is success.

Actually, that is complete codswallop. 

Warren Buffett wasn't talking about risk. Basically he was saying that "having determined your risk tolerance" the optimal way to invest is passively, through a fund tracking the index "of your choice". 

If I were a shareholder of fund C, I would be pretty pissed because of the under-performance, because I received a poor return relative to my risk tolerance. Why pay the extra cost of active management? That is failure.