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.
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.