In Warren Buffett (Trades, Portfolio)'s 2016 letter, he revisited an argument he initially made in Berkshire Hathaway Inc.'s (BRK.A, Financial) (BRK.B, Financial) 2005 shareholder letter. He argued that professional active investment management would, on average, underperform the returns achieved by amateur investors who simply invested in low-cost index funds. This argument rested on the premise the substantial fees charged by investment professionals would ultimately diminish the net returns for their clients, especially when compared to the straightforward and cost-efficient approach of passive investing.
Buffett's $500,000 wager
To put his theory into practice, Buffett issued a public challenge, offering a $500,000 wager to any investment professional who could assemble a portfolio of at least five hedge funds capable of outperforming an unmanaged S&P 500 index fund over a 10-year period. In a show of confidence, Buffett nominated a low-cost Vanguard S&P fund as his contender.
Response to Buffett's challenge
The response to Buffett's challenge was far from what one might have expected. Despite the vast number of investment managers touting their stock-picking prowess and actively encouraging others to invest billions based on their expertise, only one individual, Ted Seides, accepted the challenge. Seides, a co-manager at Protégé Partners, selected five funds-of-funds, each of which invested in over 100 hedge funds, aiming to diversify risk and ensure a fair comparison.
Outcome of the bet
It is essential to note that each fund-of-funds came with an additional layer of fees, which compounded the overall costs borne by investors. Over the nine-year duration of the bet, the low-cost S&P 500 ETF Trust ETF (SPY, Financial) delivered an impressive compounded annual return of 7.1%, while the five funds-of-funds selected by Seides returned an average of just 2.2% compounded annually. This stark performance difference resulted in the index fund outperforming the funds-of-funds by a considerable margin, ultimately highlighting the advantages of passive investing over active management.
High Fees in the investment industry
Buffett's letter also underscores the issue of high fees in the investment industry, particularly in hedge funds. Even in years when hedge funds underperformed, fees continued to be levied, substantially diminishing investor returns. This point serves as a stark reminder that costs can significantly erode the value of investments over time.
The challenge of identifying talented individuals
Further, Buffett acknowledged that while there are undoubtedly talented individuals capable of outperforming the market, identifying them in advance is a daunting task. Even those who do achieve exceptional results often struggle to sustain their performance over the long term.
Perception of the wealthy and institutional investors
The wealthy and institutional investors, Buffett observed, have a strong inclination to receive what they perceive as superior investment advice due to their financial status. They believe their money should buy them access to exclusive services and expertise. As a result, they often seek complex and costly investment strategies, leading to significant fees.
Buffett's recommendation
Buffett closed his letter with a poignant reminder of his longstanding recommendation of low-cost index funds, emphasizing they are the most sensible choice for most investors. He highlighted the detrimental impact of high fees on large institutional investors, particularly underfunded pension funds for public employees, which suffer from both poor investment performance and excessive fees. He wrote:
"When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience."
Key takeaways from Buffett's letter
Buffett's letter reiterates his belief in passive investing through low-cost index funds. He argued that, on average, professional active investment management tends to underperform passive strategies due to the higher fees charged by active managers. The bet he made with Seides serves as empirical evidence supporting his assertion.
The guru emphasized the significance of fees in investment management. Even in years when the hedge funds underperformed, their managers continued to charge high fees, significantly reducing investor returns. This highlights the detrimental effect of fees on long-term investment outcomes.
Buffett acknowledged that while there are talented individuals capable of outperforming the market, identifying them in advance is extremely challenging. Even those who do achieve exceptional results often struggle to sustain their performance over the long term.
He concluded by recommending low-cost index funds for investors of all sizes. He highlighted the adverse impact of high fees, particularly on large institutional investors such as underfunded pension funds, which suffer from both poor investment performance and excessive fees.
Conclusion
In conclusion, “The Bet” section of Buffett's 2016 letter serves as a powerful testament to the merits of passive investing, demonstrating that keeping investment costs low and adopting a long-term perspective is a winning strategy for investors. His wager vividly illustrates the challenges faced by active managers in consistently outperforming the market, especially when factoring in fees. It reaffirms Buffett's long-standing belief that most investors are better off with a simple and low-cost approach to investing, such as the S&P 500 ETF Trust.
What I learned from Buffett’s bet was not necessarily that the S&P 500 will always beat a basket of hedge funds in any given period, because for me, it depends on the risks factors driving that investing period. However, the key here is fees and costs. A low-cost tracker fund gives you broad market exposure for next to no cost. Costs are low because of economies of scale and minimal trading costs. Hedge funds with their fees and high transaction costs, added with another layer of fund of fund fees, does make the costs add up quickly. So the real takeaway for me is long-term investing, keeping a firm eye on transaction costs, which includes trading costs, so lower levels of activity are going to save you money, adding to your net investment returns. That has basically been Buffett’s investment style all along.
