Buf­fett’s ar­gu­ment for pas­sive in­vest­ing

Berk­shire Hath­away’s founder ex­plains why he ad­vises his friends to in­vest in a low-cost S&P 500 in­dex fund.

Finweek English Edition - - MARKET PLACE -

alotof very smart peo­ple set out to do bet­ter than av­er­age in se­cu­ri­ties mar­kets. Call them ac­tive in­vestors. Their op­po­sites, pas­sive in­vestors, will by def­i­ni­tion do about av­er­age. In ag­gre­gate their po­si­tions will more or less ap­prox­i­mate those of an in­dex fund. There­fore, the bal­ance of the uni­verse – the ac­tive in­vestors – must do about av­er­age as well. How­ever, these in­vestors will in­cur far greater costs. So, on bal­ance, their ag­gre­gate re­sults af­ter these costs will be worse than those of the pas­sive in­vestors.

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-neu­tral­is­ing, 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.

If Group A (ac­tive in­vestors) and Group B (do-noth­ing in­vestors) com­prise the to­tal in­vest­ing uni­verse, and B is des­tined to achieve av­er­age re­sults be­fore costs, so, too, must A. Which­ever group has the lower costs will win. (The aca­demic in me re­quires me to men­tion that there is a very mi­nor point – not worth de­tail­ing – that slightly mod­i­fies this for­mu­la­tion.)

And if Group A has ex­or­bi­tant costs, its short­fall will be sub­stan­tial.

Beat­ing the mar­ket

There are, of course, some skilled in­di­vid­u­als who are highly likely to out­per­form the S&P over long stretches. In my life­time, though, I’ve iden­ti­fied – early on – only 10 or so pro­fes­sion­als that I ex­pected would ac­com­plish this feat.

There are no doubt many hun­dreds of peo­ple – per­haps thou­sands – whom I have never met and whose abil­i­ties would equal those of the peo­ple I’ve iden­ti­fied. The job, af­ter all, is not im­pos­si­ble. The prob­lem sim­ply is that the great ma­jor­ity of man­agers who at­tempt to Chair­man and CEO of Berk­shire Hath­away Busi­ness­man, in­vestor and phi­lan­thropist over­per­form will fail. The prob­a­bil­ity is also very high that the per­son so­lic­it­ing your funds will not be the ex­cep­tion who does well.

Bill Ruane – a truly won­der­ful hu­man be­ing and a man whom I iden­ti­fied 60 years ago as al­most cer­tain to de­liver su­pe­rior in­vest­ment re­turns over the long haul – said it well: “In in­vest­ment man­age­ment, the pro­gres­sion is from the in­no­va­tors to the im­i­ta­tors to the swarm­ing in­com­pe­tents.”

Fur­ther com­pli­cat­ing the search for the rare high-fee man­ager who is worth his or her pay is the fact that some in­vest­ment pro­fes­sion­als, just as some am­a­teurs, will be lucky over short pe­ri­ods.

If 1 000 man­agers make a mar­ket pre­dic­tion at the be­gin­ning of a year, it’s very likely that the calls of at least one will be cor­rect for nine con­sec­u­tive years. Of course, 1 000 mon­keys would be just as likely to pro­duce a seem­ingly all-wise prophet.

But there would re­main a dif­fer­ence: The lucky mon­key would not find peo­ple stand­ing in line to in­vest with him.

Fi­nally, there are three con­nected re­al­i­ties that cause in­vest­ing suc­cess to breed fail­ure. First, a good record quickly at­tracts a tor­rent of money. Sec­ond, huge sums in­vari­ably act as an an­chor on in­vest­ment per­for­mance: What is easy with millions, strug­gles with bil­lions (sob!).

Third, most man­agers will nev­er­the­less seek new money be­cause of their per­sonal equa­tion – namely, the more funds they have un­der man­age­ment, the more their fees.

These three points are hardly new ground for me: In Jan­uary 1966, when I was man­ag­ing $44 mil­lion, I wrote my lim­ited part­ners: “I feel sub­stan­tially greater size is more likely to harm fu­ture re­sults than to help them. This might not be true for my own per­sonal re­sults, but it is likely to be true for your re­sults. There­fore, I in­tend to ad­mit no ad­di­tional part­ners to BPL. I have no­ti­fied Susie that if we have any more chil­dren, it is up to her to find some other part­ner­ship for them.” The bot­tom line: When tril­lions of dol­lars are man­aged by Wall Streeters charg­ing high fees, it will usu­ally be the man­agers who reap out­sized prof­its, not the clients. Both large and small in­vestors should stick with low-cost in­dex funds.

In­vestors, on av­er­age and over time, will do bet­ter with a low-cost in­dex fund than with a group of funds of funds.

War­ren Buf­fett

Bill Ruane

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