Warren Buffett: investors should stick to low-cost tracker funds

warren-buffett-berkshire-hathaway-headshot

Over the weekend Warren Buffett, arguably the world's most famous investor, published his annual shareholder letter, where he once again waded into the active versus passive debate.

In the letter Buffett characterised active fund managers as 'smart people' who 'set out to do better than average in securities markets'. Meanwhile, their opposites - passive investors - will by definition do about average.

Seeing as active investors charge much higher fees, argued Buffett, their aggregate results after these costs will be worse than those of the passive investors.

Warren Buffett's a fan, but do trackers beat active funds?

MILLION-DOLLAR BET

In 2008, Buffett famously and very publicly hatched a million-dollar bet with the money management firm Protégé Partners.

Buffett bet that an index fund which invests in the S&P 500 - he chose Vanguard 500 Index Fund Admiral Shares - would perform better than five active 'fund of funds' picked by the company.

After nine years, Buffett's index fund is up by 85.4 per cent, while the selection of the five funds is up 22 per cent. The bet still has a year to run but it certainly looks like Buffett's going to win.

Further, in 2014 Buffett revealed in his annual shareholder letter that he had instructed the executors of his will to buy an index tracker for his widow. He also named his preferred choice - Vanguard's S&P 500 index fund.

'Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor's equation,' said Buffett of active investing, adding '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.'

NOT THE INVESTORS WHO PROFIT

While he conceded that active outperformance is not impossible, he argued the problem simply is that the great majority of managers who attempt to beat the market will fail.

Further he said some investment professionals 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.'

He also cautioned that 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.'

The bottom line, according to Buffett, is that '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'.

Therefore, he concludes that both large and small investors should stick with low-cost index funds.


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