Conjure up a name in finance. Any name. One of the most recognizable individuals with a good chance of being the name you came up with, Warren Buffet, spoke at the recent 2016 Berkshire Hathaway Shareholders Meeting to give his evaluation of the market as well as Berkshire Hathaway’s performance. One thing he also provided was his well-known position on actively versus inactively managed funds. His stance may not be what you expect of the normal billionaire.
The “Oracle of Omaha” preached his views clearly and with good data to support his claims. A key insight he shared was that in evaluating humans and businesses, Buffet has noticed that many investments appear to be profitable in the short run, but not in the long run. In a story mentioned in a previous blog post, Buffet entered into a bet with Protégé Partners, declaring that the S&P 500 index fund could outperform and do better than the top five hedge funds. A pretty surprising bet don’t you think? However, upon checking on the bet during the Shareholder’s Meeting, Buffet has shown himself to be quite right. The performance of the S&P 500 beat the hedge funds by a mile: 65.7% (S&P 500) versus the hedge funds’ 21.9% as of end of 2015.
How can this be? Aren’t hedge funds supposed to outperform? Well, in breaking down the reason why the S&P 500 index did so much better than the actively managed hedge funds, Buffet reveals the logic behind passive investing. In a hypothetical situation, Buffet relates his wager to half of all investors buying half of all stocks and sitting on it, without influence of stock prices, news, or financial publications and the other half of all investors actively investing the other half of stocks. The inactive investors will perform exactly average due to the fact that they have had low fees and the stocks have performed exactly as the market had. On the other hand, while the actively invested group has the same gross result on average, they MUST be underperforming due to the high amounts of fees they have accrued. The very fact that the funds are actively managed is what instantly makes the investment less and less profitable than the average. This rationale is, in fact, exactly what Nobel Laureate William Sharpe famously outlined in an easy-to-read three page 1991 article “The Arithmetic of Active Management” published in the Financial Analysts Journal (http://www.cfapubs.org/doi/pdf/10.2469/faj.v47.n1.7).
If it is so obvious that patient investing is more profitable and less expensive than active trading why do we still actively trade? In evaluating the nature of these groups, Buffet remarks that those who actively trade the most are wealthy, and generally seek consultants or hedge fund managers to help them invest. Unfortunately, it is directly in the consultant or money manager’s best interest to invest actively because that is the way these high-level executives and stock-brokers make money. It is not to the benefit of the consumer that a consultant recommends (hyper)active investing. Buffett quips that Wall Street is extremely gifted at selling, but a lot less gifted in making money for their clients.
Consequently, the “Oracle of Omaha” truly preached against the involvement of consultants and hedge fund managers, calling attention to the lack of value added and the strain on gains for the consumer. In a book titled “Where Are The Consumers’ Yachts?” by Author Fred Schwed, the salesmanship of Wall Street managers is nicely shown to be the key reason for underperformance. If the money managers are making such high gains and can live luxurious lifestyles, sailing around on yachts, how come their clients do not own any yachts, after all? The short answer: the clients can’t afford them anymore after the successful wealth transfer from client to Wall Street money manager cum newly minted Yacht owner.
Sources:
https://finance.yahoo.com/brklivestream/
http://blogs.wsj.com/moneybeat/2016/05/02/warren-buffetts-epic-rant-against-wall-street/?mod=e2fb
http://www.cfapubs.org/doi/pdf/10.2469/faj.v47.n1.7
https://www.amazon.com/Where-Are-Customers-Yachts-Street/dp/0471770892