The Simple Reason Passives Produce Better Results

The Simple Reason Passives Produce Better Results
Underwater by Andy Deitsch Why?

All You Need To Know About Passive Investing

This article is part of a series. To view all the articles in the series, click the button below.

All You Need To Know About Passive Investing

In 2007, Warren Buffett bet one million dollars that passives would beat the best hedge fund managers over 10 years and he’s well ahead to date: watch the video below to discover the reason why "doing nothing" consistently beats active fund management.

The Irrefutable Evidence That You Could Make More Money Investing In Passives

The Video Reveals Why Warren Buffett Prefers Passives

It’s not as if one of the world’s richest men needs to prove his preference for passives.  But recent research published by Citywire seems to confirm that ‘do nothing’ passives consistently outperform active funds, as three quarters of actively managed UK equity funds fail to beat the stockmarket over 10 years.

Further afield, the vast majority of actively managed US, global and emerging market equity funds have underperformed their respective benchmarks over the past 10 years, causing the value of active fund management to come into question.

According to research from index provider S&P Dow Jones, only 3 per cent of actively managed US equity funds beat the S&P 500 index over the 10 years to the end of June. Over the past year, the percentage of US equity funds that trailed the index also remains high at 92 per cent.

In emerging market equities, 85.2 per cent of funds were unable to match the performance of benchmarks over 10 years. Meanwhile, 95 per cent of global equity funds underperformed over the past decade.

The Simple Reason Passives Produce Better Results

More than seven hours of video was recorded at the 2016 Berkshire Hathaway Annual Shareholders Meeting.  To discover Warren Buffett’s reason why passives should always perform better over a longer periods, start the video at 2 hours 42 minutes and 35 seconds and watch for seven minutes.  The text is shown at the bottom of this article should you prefer to read rather than watch.

Investing In Passives – September 2016

In a series about passives on FT Adviser, you’ll see why in current volatile markets, passives are proving popular.  The areas are covered in detail:

  • Buying into less-common strategies
  • Strategy’s ‘sweet spot’ for investors
  • No sign of passives slowing down as capabilities expand
  • Beware ‘the lower, the better’ mindset; investors should focus on other factors

The Simple Reason Passives Produce Better Results

Some years ago I made a wager, and I promised to report before the lunch of how the wager was coming out, and I’ve been doing that regularly but it probably seems appropriate since it’s developed thus far to point out a rather obvious lesson which is what I hoped to drive home to some degree by offering to make the wager originally.

Incidentally, when I offered to make the wager, namely that somebody could pick out five hedge funds and I would take the Managed S&P Index Vanguard Fund and I would bet that over a 10 year period that the unmanaged Index would beat these five funds that were all being managed, presumably.  They could pick any five funds that were being managed by people who were charging incredible sums to people because of their supposed expertise. 

And fortunately, there’s an organisation called, or at least if you go to the internet and put in longbets.org. It’s a terribly interesting website.  You can have a lot of fun with it because people take the opposite side of various propositions that have a long tail to them, and make bets as to the outcome, and then each side gives their reasons.  You can go to that website and you can find bets about what population will be doing in 15 years from now – all kinds of things – and our bet became quite famous on it.  A fellow I like, and who I didn’t know before this, decided he could pick out five hedge funds – these were ‘fund of funds’, ie one hedge fund at the top and that manager picked out who he thought were the best managers underneath, and he bought into these other funds in turn, so that the five funds of funds represent maybe 100 or 200 hedge funds underneath.

Now bear in mind that the hedge fund from the fellow making the bet was picking out funds for the manager on top was perhaps getting paid 0.5 per cent per year, plus a cut of the profits for merely picking out what he thought were the best managers underneath, who in turn were getting paid maybe 1.5 or 2.0 per cent, plus a cut of the funds’ profits.  But certainly the guy at the top was incentivised to try and pick out great funds and at the next level, those people were presumably incentivised too.

So the result is after eight years, and several hundred hedge fund managers being involved, that there is now, the totally unmanaged fund with Vanguard, with very, very minimal cost is now 40-some points ahead of the group of hedge funds.

Now that might sound like a terrible result for the hedge funds, but it’s not a terrible result for the hedge fund managers.  These managers – you’ve got this top level manager who’s probably charging 0.5 per cent, I don’t know that for sure, and down below, you’ve got managers who are probably charging 1.5 to 2.0 per cent.  So you have a couple of percentage points sliced off every year.  That is a lot of money.

We have two managers at Berkshire, and each manager manages 9 billion dollars for us.  They both ran hedge funds before.  If they have a two and 20 arrangement with Berkshire, which is not uncommon in the hedge fund world, they would be getting 180 million dollars each, you know, merely for breathing, annually.  It’s a compensation scheme that is unbelievable to me, and that’s one reason I made this bet.

But what I’d like you to do is, for a moment, imagine that in this room, we have the entire, you people, own all of America - all of the stocks in America are owned by this group.  You are the Berkshire 18,000 or whatever it is, that have somehow managed to accumulate all the wealth in the country.  And let’s assume we just divide it down the middle, and on this side, we put half the people – half of all the investment capital in the world – and that capital is what a certain presidential candidate might call ‘low energy’.  In fact, they have no energy at all.  They buy half of everything that exists in the investment world.  50 per cent. Everyone on this side.  And so half of it is now owned by these ‘no energy’ people.  They don’t look at the stock prices.  They don’t turn on business channels.  They don’t read the Wall Street Journal.  They don’t do anything.  They are a slovenly group that just sits for year after year after year owning half of the country, half of America’s business.

Now what’s their result going to be?  Their result is going to be exactly average of what all American business does, because they own half of it.  They have no expenses.  No nothing. 

Now what’s going to happen with the other half? 

The other half are what we call the ‘hyper-actives’.  And the hyper-actives – their gross result is also going to be a half.  Right?  The whole has to be the sum of the parts here in this group.  By definition, it can’t change from its half of the ultimate investment result.  This half is going to have the same gross result as the ‘no energy’ people, and they are also going to have terrific expenses because they’re always moving around, hiring hedge funds, hiring consultants, paying lots of commissions and everything, and that half as a group has to do worse than this half.  The people who don’t do anything have to do better than the people who are trying to do better. 

And it’s that simple!!!

Warren Buffett

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