Warren Buffett, the Chairman of Berkshire Hathaway since 1970, sometimes called the “oracle of Omaha,” is arguably the world’s most successful stock-picking investor. Under his leadership Berkshire Hathaway has grown to a financial powerhouse, with total market capitalization of approximately USD$420 billion. Buffett has certainly shared in this success — as of this writing (27 February 2017), Buffett’s net worth was USD$76.5 billion, making him the second wealthiest person in the world.
So what advice does Buffett have for the rest of us mere mortals, individual investors as well as institutional investors?
His answer is quite arresting: Invest mainly in broad-market index-tracking funds with very low fees.
Buffett’s bet with a hedge fund
In his 2017 letter to stockholders, released 25 February 2017, Buffett mentioned a bet he made nearly 10 years ago, where he challenged an asset manager for the hedge fund Protege Partners that a low-cost S&P 500 index-tracking fund would outperform a basket of hedge funds. In his letter, Buffett provided an update: the basket of hedge funds had average compound annual returns of 2.2% through 2016; the index fund has returned 7.1%, more than three times as much.
Buffett’s bet, which he almost certainly will win, ends on 31 December 2017. He has promised that his winnings will be donated to charity.
Why such poor performance by hedge funds?
Buffett points his finger at the large fees assessed by the hedge funds — he estimates that approximately 60% of the gains achieved by the hedge funds were lost to management fees over the past ten years. He writes, “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.” He added “Both large and small investors should stick with low-cost index funds.”
Buffett recently calculated that over the past ten years, wealthy investors, pension funds and other institutional investors have lost roughly USD$100 billion to fees charged by hedge funds and other high-fee investment vehicles. He adds, “my calculation of the aggregate shortfall is conservative.”
Buffett also emphasized that these high fees have consequences:
Much of the financial damage befell pension funds for public employees. … Many of these funds are woefully underfunded, in part because they have suffered a double whammy: poor investment performance accompanied by huge fees. The resulting shortfalls in their assets will for decades have to be made up by local taxpayers.
Buffett continued by heaping praise on Jack Bogle, the founder of Vanguard Group, which pioneered very low-cost index-fund investment.
Along this line, Buffett clearly practices what he preaches, at least for that portion of his personal fortune that is to be inherited by his wife and heirs. He has instructed the trustee of his estate, after he dies, to invest at least 90% of the money in low-cost S&P 500 index-tracking funds, and the remainder in government bonds.
Will increased indexing threaten the health of the market?
One question that is frequently raised is whether a large-scale movement to passive indexed investing would threaten the health of the system.
There are certainly some legitimate grounds for concern here. After all, the investing world will always require at least some investors who address fundamentals, who read quarterly reports and who continually reassess the value of a particular firm’s stock and bond offerings in light of current news, both about the firm itself and also the ever-changing landscape of economic environment and competitors in the firm’s sector. Clearly if 90% or more of a market were passively indexed, that market would be quite unstable, subject to wrenching volatility when, for example, some trader accidentally sells far too many shares, as in the 2010 flash crash. Even, say, 70% would be cause for concern.
However, we are still quite some distance from this level of passive investment. A December 2014 tabulation of U.S. market data found a total equity capitalization of USD$21.7 trillion, of which USD$2.6 trillion, or 12.1% was passively indexed. So U.S. equity markets have a long ways to go before passive investment becomes a significant stability issue. European and Asian markets are even further from the level of concern.
The difficulty of beating the market
As we have pointed out in several previous blogs (see, for example, Blog A and Blog B), we should not be terribly surprised at the fact that even the best hedge funds and other highly professional investment organizations have difficulty consistently beating the market. Since markets by definition incorporate the collective judgments of many thousands of participants worldwide, including quite a few organizations who employ very sophisticated mathematical algorithms and high-frequency trading software (often canceling out each others’ efforts), it follows that equity markets are reduced to time series that exhibit many of the statistical characteristics of a random walk (including unpredictability).
A few organizations, such as the Renaissance Medallion Fund, and a few individual managers, such as Warren Buffet, have indeed been able to beat the market averages over a sustained period of time. But replicating this success is, by definition, very difficult, and even more difficult to prove statistically.
According to an ancient account, when Pharaoh Ptolemy I of Egypt grew frustrated at the degree of effort required to master geometry, he asked his tutor Euclid whether there was some easier path. Euclid is reputed to have replied, “There is no royal road to geometry.” Indeed. And there is no royal road to investment either.