Date posted: 03/07/2018 9 min read

Ditch hedge funds and go passive - Buffett

Warren Buffett says his winning 10-year bet on a simple index proves investment returns delivered by active investment experts don’t justify their fees.

In Brief

  • The use of index funds is on the rise in Australia as investors question the steep fees charged by active managers.
  • Investment advisors say investors should interpret with caution Warren Buffett’s winning bet on index funds.
  • Buffett’s winning bet on index funds brings added scrutiny to fund managers.

By Ben Hurley.

For most of the 21st century, active investment managers have been losing market share in retail investment to cheaper, index-tracking passive managers. The active managers have been under pressure from a low-return environment, which makes fees look larger. And most small investors now just place their money in a fund, which means that savvy institutional investors dominate the market.

And now a winning 10-year investment bet by the most famous investor of them all, Warren Buffett, has made the gap between index-tracking and actively managed funds clearer than ever before.

Buffett is the legendary chairman and CEO of US-based business investor Berkshire Hathaway. And he has just revealed his victory in a 10-year “long bet” with hedge fund investor Ted Seides.

The bet, lodged on at the end of 2007, was that the S&P500 would outperform a portfolio of funds of hedge funds over a 10-year period, measured net of fees and expenses. Buffett chose a cheap and transparent index fund that tracks the S&P500. Seides chose five funds-of-funds selected by asset management and advisory firm Protégé Partners, where Seides worked at the time the bet was made; the five funds in turn owned interests in more than 200 hedge funds.

Photograph: Steve Pope/Getty Images

Betting against the brains

The hedge fund managers were “an elite crew, loaded with brains, adrenaline and confidence”, Buffett tauntingly wrote in a letter to shareholders of his Berkshire Hathaway investment company, released in February.

Yet Buffett’s simple index fund investment utterly trounced the returns generated by the hedge funds. From 2008 to 2017, Buffett’s index fund returned 8.5%. The hedge fund portfolio returned yearly averages ranging from 0.3% to 6.5% compounded annually, net of all fees.

Despite worse returns than Buffett’s simple index, all the hedge fund managers enjoyed a mix of performance incentives, along with generous fixed fees averaging 2.5% of the assets every year. 

There was “nothing aberrational” about how the stock market performed over the period, Buffett wrote in his letter to shareholders. His simple question to investors: Does anyone get any value in return for the fees they pay to these people?

“Making money in that environment should have been easy,” Buffett wrote. “Indeed, Wall Street ‘helpers’ earned staggering sums. While this group prospered, however, many of their investors experienced a lost decade.”

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Lessons from the bet

The bet illuminated several investment lessons, Buffett said. Investors need to “disregard mob fears”, “focus on a few simple fundamentals”, and be willing to “look unimaginative for a sustained period”.

Another lesson came when Protégé and Buffett agreed to trade the US Treasury bonds they had both used to fund their portions of the bet for Berkshire Hathaway shares, after the bonds became a “really dumb investment” compared to equities. Berkshire’s performance led to Buffett’s charity, Girls Inc. of Omaha, receiving US$2.2 million instead of the original bet bounty of US$1 million.

This proved investors should “stick with big, ‘easy’ decisions and eschew activity”, Buffett wrote. While the 200-plus hedge-fund managers on Protégé’s side of the bet had made many thousands of heavily researched buy-and-sell decisions, Buffett and Berkshire Hathaway had made only one, based on a “kindergarten-like analysis” – and it had led to a huge windfall.

Fund managers’ tricks revealed

The bet shone a light on what was already a widely known truth: managers of active investment strategies have a sketchy track record of beating the market.

Australian stock pickers don’t fare much better than the investment managers Buffett was up against. S&P Dow Jones Indices’ score card for professional stock pickers found that, over 2017, six in 10 large-cap Australian equity funds underperformed the S&P/ASX200 benchmark. Over the longer term, they did even worse. Over three years, 67% of “core” Australian share funds lagged the market; over 10 years the figure rose to 74%. 

Performance comes, performance goes. Fees never falter.
Warren Buffett CEO, Berkshire Hathaway

S&P Dow Jones also found when funds did outperform, very few continued their winning streak over five consecutive years. 

The investment management industry has come under increasing scrutiny in recent years for its high fees and lack of transparency. In the UK, the Financial Conduct Authority’s (FCA) review into asset managers found some funds that charge fees for active management may actually be passive funds in velvet-lined boxes. It estimated in its final report into the sector in June last year that around £109 billion was invested in funds which claimed to be active and were significantly more expensive than index-tracking funds, despite closely mirroring the market themselves.

There was no clear relationship between the performance of retail funds in the UK and the fees they charged, the FCA found. Alex Dunnin, executive director of research at financial services information group Rainmaker, argues passive investing has lifted the lid on the magic tricks of hedge funds which once claimed great returns because of fine judgement and shrewdness.

In reality, many were following quantitative analysis formulas such as price–to-earnings ratios or other revenue KPIs. With index funds automating much of this, these funds can no longer claim the credit they used to claim. “What indexing has done is really shown up who are the people who really have the skills and who are the folks who claim to have the skills,” Dunnin says. “Just because you have a good distribution network doesn’t mean you are good at funds management.”

Passive risks

Investors continue to pile money into actively managed funds. “CBA as the biggest company is 7.7% of the [ASX200] index,” says Giselle Roux, a highly respected investment strategist and chief investment officer at Escala Partners. She warns that investing solely in an Australian index fund risks creating a poorly diversified portfolio. “The four banks are 22.2% [of the index] and they travel in a pack. Globally the biggest stock in the MSCI All Country Index is Apple at 1.95%. Here if I invest in the index, I’m taking a massive bet on banks.”

Picking the right index fund

Australia has been somewhat of a haven for active management, but passive is on the rise. About 18% of Australia’s investment management market is indexed to a total of about A$400 billion, Dunnin says, and this number is growing fast. “Ten years ago the ratio was about half that,” Dunnin says. “So the tide is in favour of indexing.”

The easiest way to get passive exposure to the Australian or New Zealand equity markets is by buying into an exchange-traded fund (ETF). These can vary by the passive investing methodologies they follow. The simplest and most transparent invest in stocks by their market value in line with an index such as the ASX300. International asset management giants such as BlackRock have launched exchange-traded funds in recent years, along with local players such as Platinum Asset Management. The ASX website maintains a comprehensive list, complete with charts tracking their recent performance. 

The value lost

Warren Buffett made his 10-year bet because he believes in a simple idea: in the long term, the investment returns delivered by active investment experts don’t justify their fees. His discussion of his bet ends with a seven-word encapsulation of that problem: “Performance comes, performance goes. Fees never falter.”

Ben Hurley is a specialist investment journalist currently based in Taipei.