The Oracle’s Wager

When Warren Buffett, Chairman and CEO of Berkshire Hathaway Inc., discusses investing, most everyone in the financial industry pays attention.  No one can disagree with his success or business acumen and few seem to be better at picking stocks.  However, when Mr. Buffett criticized hedge funds back in 2007 for their heavy fees, one hedge fund manager decided to challenge him to an investment duel.  With a hefty bet of $500,000 on the line for charity, the wager was made to determine which strategy could perform better over a 10-year time frame – passive index funds or actively managed hedge fund strategies.  Articles in the WSJ and Fortune last week are spotlighting the performance battle, which will conclude at the end of 2017.  Mr. Buffett picked a low-cost S&P 500 index fund run by Vanguard and the former hedge fund manager, Ted Seides from Protégé Partners on Wall Street, chose five unnamed hedge funds.  While Mr. Seides agreed that over time the expenses from active management would eat into the returns to investors, he believed that an “unusually well-managed hedge fund portfolio” could be superior over time.

According to Fortune, who reports annually on the bet, the results, at this point, are not even close!  The index fund has recorded an annual increase of 7.1% for a total of 85.4% since the start of the bet.  The hedge fund has registered gains of an annual 2.2% or total average gains of 22%.  The discrepancies have been aided since 2007 by an extended bull market and poor hedge fund performance overall.  As Mr. Buffett states in his letter to his stockholders from February 25th, 2017, the performance average of the 5 hedge funds “were really dismal.”  Apparently, short of a complete market-meltdown, Girls Inc. of Omaha, Nebraska will get a nice contribution from Protégé Partners, thanks to Mr. Buffett.

As the WSJ points out, though, Mr. Buffett made his fortune by savvy investing in individual companies and undervalued stocks with his own brand of active management.  Not exactly a shining example for passive investing!  Mr. Buffett, also known as the Oracle of Omaha, releases an annual shareholders’ letter that is always highly anticipated.  One of his themes this year is passive investing versus active investing and his belief that “passive will beat active over time”.  Mr. Buffett has been critical in the past of investment managers for charging high management fees even when their funds underperform.  He encourages investors to use low-cost index funds and states in his letter from last week – “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.”  At DWM, we completely agree with Mr. Buffett on the benefits of passive vs. active investing for traditional asset classes like equities and fixed income.

However, here is where we see things differently.  Mr. Buffett is a billionaire and certainly has a monumental tolerance for risk.  Mr. Buffett has a history of making his fortune investing in exactly the companies included in this Vanguard index fund – the 500 top U.S. large-cap entities.  In contrast to the performance for the last 9+ years, had the bet occurred in the decade prior, Mr. Buffett would be the one on the losing end of the battle.  Since even the Oracle himself cannot predict how the market will perform going forward, at DWM, we believe in the low-cost benefit of passive index funds, but we also strongly believe in asset class and asset style diversification that will protect our clients who do not have the risk tolerance profile of Mr. Buffett.  We use index funds from several classes of equities, not just the S&P 500.  We use a diversified mix of domestic and international small and large cap funds.  We also use other asset classes to “hedge” our exposure to equities by using fixed income funds and alternatives.  We want to protect the assets of our clients, participating when the markets are up like in 2016, but protecting against downturns like in 2008.   A client portfolio with a balanced allocation might be a couple of percentage points below Mr. Buffett’s choice of index fund in various short term time periods, but our use of diversification instead of this concentrated investment style should lead to smoother returns, less downside, and ultimately better long-term results.

Mr. Buffett is an example of business leadership and financial prowess.  In his case, we think his advice to put your investments in low-cost and passive index funds is solid.  He is, however, an example of “do what I say, not what I do” in his investing style and we believe that trying to emulate the investing career of Warren Buffett should come with a warning label – don’t try this at home!  However, we applaud his advice on passive investments, but want to add that, unless you are a billionaire and can weather that amount of risk, diversification is critical to your success.  A strong mix of passive investments and diversification will do better over time.  You can bet on it!

“(One of) The Most Powerful Ideas in Investing”

active-vs-passive-investing-300x166 4In the last fifteen months, $215 billion has moved out of actively managed mutual funds into passively managed index funds and Exchange-Traded Funds (“ETFs”).  It’s possible another $2.5 trillion will migrate out of actively managed funds in the next decade.  Noah Smith in Bloomberg View last week suggested this transition may be “the biggest story in the finance industry during the past decade; larger than the 2008 financial crisis.”  In fact, Mr. Smith titled his article “The Rise of the Most Powerful Idea in investing.”

There are five major reasons astute investors use passive investments for mature markets, such as most equity and fixed income asset classes:

  • The “Efficient Market Hypothesis,” an investment theory for which Eugene Fama won a Nobel Prize, states that it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. As a result, it should be impossible to “outperform” the overall market through expert stock selection or market timing.
  • Modern technology allows index mutual and ETFs to construct portfolios that track indices closely and inexpensively. Some index funds have an operating expense ratio of .05% or less.
  • In general, actively managed funds over time have underperformed. It’s pretty simple math. Investors in actively managed funds are paying higher operating fees and sometimes front-end loads and marketing fees as well.  All in all, some actively traded funds have expenses over 1.5% per year, while a similar exposure in the markets using passive funds could cost .35% or less.  People trying to beat the market are likely to lose, since they tend to be trading on stale information, while paying higher fees at the same time. On average, the 1% or more of costs result in underperformance of a similar magnitude.  Over time, this has a huge negative impact on wealth creation.
  • Low interest rates are producing lower returns which make investment costs more noticeable and painful, pushing people toward low-fee passive investment vehicles.
  • The new “Fiduciary Rule” issued by the Department of Labor has brought more public awareness to the difference between brokers and Registered Investment Advisers (“RIAs”) like DWM.  Many investors previously thought that any financial advisor was a fiduciary and hopefully looking out for the clients’ best interests.  When, in fact, some brokers were looking out for their own best interests, selling actively managed funds that produced more income for the broker, while reducing the potential performance for the investor.

We may now have hit a real “tipping point” in the “debate” over actively managed vs. passively managed investing.  In the latest sign of the change, yesterday Charles Schwab & Co. announced it is taking mutual funds with sales loads off its shelves.   These “Class A Load Shares” have become a
“tiny fraction of Schwab’s mutual fund business overall” according to A Company spokesman.

To conclude, while some, such as Mr. Smith, would say that the migration from actively managed investing to passive investing is the “most powerful idea in investing”, we at DWM see this “idea” as just one of the key building blocks of sound investment management.  You regular DWM blog readers and seminar attendees hopefully can recite with us the remaining factors by rote:

  • Creation of an investment plan to fit your needs and risk tolerance
  • Identifying an appropriate asset allocation
  • Structuring a diversified portfolio
  • Reducing expenses and turnover (including use of passive investments for mature markets)
  • Minimizing Taxes
  • Monitoring (by comparison to benchmarks) and rebalancing regularly
  • Staying invested

All of these controllable activities are powerful ideas that can assist you, with the help of your wealth manager if you desire, to add significant value to the management of your investment portfolio and enhance the ability to protect and grow your assets.