As usual, Buffett begins his annual letter with an update on Berkshire Hathaway’s relative performance, its growth in book value per share against the total return of the S&P500 index.
This is the stuff of the Buffett legend. The index returned 9,7% pa over the past 52 years whereas Berkshire’s book value grew by 19,0% pa. $100 tracking the S&P500 since 1965 would now be worth $12,717; the same amount invested by Berkshire $884,319. That’s 70 times more!
While just about every investor will regret missing out on this phenomenal wealth creation, they can console themselves with the fact that this type of outperformance was not foreseeable.
The “self-inflicted wound” of fees
But just as instructive is the comparative growth in Berkshire’s market value per share. At 20,8% pa it is just 1,8% higher than the growth in book value.
Not a big difference, you would think, but it means that $100 invested in Berkshire shares would have grown to $1,972, 595, more than double the growth in book value.
Our point: compounding a seemingly small difference of 1,8% pa over 52 years makes a huge impact. Yes, that’s a long time to be invested, but those who save and invest through-out their working life and beyond will easily match that. Unfortunately, many of these people do pay away 1,8% pa more in fees than they need to, costing them half their nest egg.
These fees are paid to brokers trading shares, to fund managers trying to build a winning portfolio, and to consultants trying to identify the winning fund managers.
But investors only have themselves to blame as this fee impact is entire foreseeable. Buffett calls it a “self-inflicted wound”.
He has railed against this “frictional cost” of active investing for many years. As far back as 2005, he cautioned readers that these “are in a major way cutting the returns they will realize from their investments.” Investors would do better with an unmanaged low-cost index fund (such as offered by 10X, for example) simply due to the enormous fee saving.
Index ‘tortoise’ versus hedge fund ‘hare’
It was at this time that he wagered $500,000 that no investment pro could select at least five hedge funds that would over ten years match the performance of a low-cost S&P500 index fund.
Incredibly, of the many thousands who boast their active management skills only one stepped up to defend their occupation.
The now-famous wager still has one year to run, but all (side) bets are long off. The $1m tracking the index has thus far grown by $854,000, the same amount invested equally across the five selected fund of hedge funds to just $220,000. The best gained $628,000, the worst a mere $29,000.
And even though all these funds performed poorly for their investors, many of the underlying fund managers would have grown extraordinarily rich, simply by piling up assets and collecting their annual management and occasional performance fees.
Active managers doomed to fail
Fund managers revere Warren Buffett for his track record which, they argue, legitimizes active investing. Many try to emulate his investment philosophy.
But the admiration is not mutual. In Buffett’s words, “the great majority of managers who attempt to over-perform will fail”. Almost as an aside to the many would-be Buffetts, he borrows a quote that “in investment management, the progression is from the innovators to the imitators to the swarming incompetents.”
The failure of active managers is no great mystery but down to simple arithmetic. Passive investors, by definition, earn the average market return, so the balance of the universe (active investors) must do about average as well. However, due to the much higher cost, their aggregate net result will be worse than those of passive investors.
Beating the market is also no simple matter. Many smart people play at this game so “their efforts are self-neutralizing” and cannot “overcome the costs they impose on investors”. Some fund managers will succeed but the chances are high that the “person soliciting your funds will not be the exception who does well.”
And success tends to breed failure. A good record attracts huge inflows, which makes it harder to outperform. “What is easy with millions, struggles with billions”. Yet these manages continue to pursue more money, to further boost their income.
Expensive advice
So when Buffett is asked for investment advice, he regularly recommends a low-cost index fund (the S&P500 in the US context).
Investors usually lap up everything he says but somehow “none of the mega-rich individuals, institutions or pension funds” want to follow this most sage piece of advice. Instead they pursue a high-fee manager or, in the case of institutions, a consultant, hoping to do better.
Buffett is particularly critical of the latter. Rather than risk large fees by telling clients to add to their broad market index fund, they regularly recommend small managerial changes “in esoteric gibberish that explains why fashionable investment styles or current economic trends make the shift appropriate.”
Buffett estimates that wealthy individuals in the US have “wasted more than $100 billion over the past decade” trying to earn superior returns with hedge funds. And many US public employee pension funds are underfunded due to the double whammy of “poor performance accompanied by huge fees”.
Bottom line
Rather than deliver superior returns to their clients, active investors are mainly active in the transfer wealth from savers to fund managers. In Buffett’s own words, “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.”
His antidote is simple: “Both large and small investors should stick with low-cost index funds.”
