Warren Buffett hates hedge funds.

He really does. The legendary investor publicly criticized hedge funds at this year’s annual Berkshire Hathaway shareholder meeting, calling them a “huge minus” for investors. Not one to mince words, Buffett had previously slammed hedge funds as a “compensation scheme” masquerading as an asset class.

What are hedge funds and why have they drawn the legendary investor’s ire?

Hedge funds are private investment ventures which cater to wealthy individuals and institutional investors.  Since these investors are considered “qualified,” hedge funds are not scrutinized by regulatory agencies the way other investments are. While hedge funds use a wide variety of strategies, the basic idea is that smart managers unencumbered by the rules which govern funds available to the masses can outperform the market. Apparently, there’s no shortage of folks who buy into this idea, as today there are more hedge funds than traditional mutual funds and the industry now manages more than $3 trillion.

Warren Buffett, however, takes the view that high fees charged by hedge funds—typically 2% of assets plus 20% of the gains—ultimately doom hedge funds to underperform the market averages. Here’s what Buffet had to say in 2008:

Costs skyrocket when large annual fees, large performance fees and active trading costs are all added to the active investor’s equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.

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.

So what did Buffett do? He put his money where his mouth was, entering into a $1 million bet with hedge fund manager, Ted Seides, of Protégé Partners around the same time he made the comments above. Buffett wagered that Vanguard’s S&P 500 Index Fund, designed to track the average performance of large American companies, would deliver better returns than hedge funds over a ten-year period. Seides picked a collection of hedge funds that he was confident would outperform.

Buffet’s bet with Seides has received widespread media coverage, for a few reasons. First, Buffett’s vocal criticism of hedge funds has attracted industry attention. When Buffett speaks, people listen.  Second, the large size of the bet—one million dollars, donated by the winner to his favorite charity*—has captivated public interest. What’s garnered headlines the most, however, is the fact Buffett is winning the bet—by a landslide.

Eight years in, the Vanguard S&P 500 Index Fund picked by Buffett is up nearly 66% while the hedge funds are up only 22%. Interestingly, the hedge fund would be doing better (+45%) were it not for those pesky fees. That’s right, the high fees charged by the hedge fund and funds of hedge funds in which the hedge fund invests have consumed nearly half the return. And that’s before taxes!

Now, it’s possible the hedge funds can turn the bet around, but they’d need to stage quite a comeback. And it’s not as if the S&P 500 Index has exactly delivered eye-popping returns since the bet’s inception. Since 2008, large cap U.S. stocks are up about 6.5% per year, far less than their historical average. Indeed, Ted Seides and his selection of hedge funds would need a monumental turnaround to win the bet—possible, but not probable.

Investing in a manner which provides the most probable chance for success is what Vista has been about since our inception fifteen years ago. That means resisting the temptation to invest in what’s popular or what might possibly do well, and to instead adhere to a broadly diversified portfolio that drives down costs, minimizes taxes and stacks the odds in our clients’ favor.  Hedge funds don’t meet that test, which is why Warren Buffett despises them.

It’s no surprise then that Buffett loves index funds. In his 2013 annual letter to shareholders, Buffett again put his money where his mouth was, instructing the trustee overseeing money to be bequeathed to his wife to put 90% in a low-cost index fund (“I suggest Vanguard’s”).

Herein lies the lesson all investors can learn from the world’s most legendary stock picker:  If you look in the mirror and see anyone other than Warren Buffett, take his advice and invest in index funds.

 *Buffett’s bet with Seides will give one million dollars to the winner’s charity of choice after ten years.  Buffett picked Girls Inc. of Omaha, while Seides chose Absolute Returns for Kids. Being investment folks, however, the two sides agreed to pre-fund the $1 million prize.  Each put up $340,000, half of the amount needed to buy zero-coupon Treasury bonds which would be worth $1 million by the contest’s end.

Ironically, with the “flight to quality” and declining interest rates which characterized the global financial crisis of 2008, the value of the zero coupon bonds soared. By the end of 2012, the bonds had appreciated so much in value, Buffett and Seides agreed to sell the bonds and invest the proceeds in Berkshire Hathaway stock. Buffett has guaranteed the winner’s charity the ending value of the Berkshire shares purchased or $1 million, whichever is greater.  Today, the value of that Berkshire stock is nearly $1.7 million.