Warren Buffett, in his latest letter to shareholders of Berkshire Hathaway showcases how funds managed by professionsal fund managers have underperformed the amateurs. He start with two betting stories that are still awaiting results. In 2002, entrepreneur Mitch Kapor asserted that “By 2029 no computer – or ‘machine intelligence’ – will have passed the Turing Test,” which deals with whether a computer can successfully impersonate a human being. Inventor Ray Kurzweil took the opposing view. Each backed up his opinion with $10,000. He mentions that he has now clue about who will win this bet, but will confidently wager that no computer will ever replicate Charlie (The one and only Charlie Munger!!)
In the second bet, Craig Mundie of Microsoft asserted that pilotless planes would routinely fly passengers by 2030, while Eric Schmidt of Google argued otherwise. The stakes were $1,000 each. Here Warren Buffett is supporting Eric and had put his share of $500.
Then Warren comes to a bet he mentioned in the 2005 Berkshire Hathaway’s Annual letter. In Berkshire’s 2005 annual report, he argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. He explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund.
Warren Buffett publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees.
I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation.
Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to his challenge. And after 12 years Bufett comes with data to show that S&P Index Fund has given more net return than the so called fund managers.
Below are the reasons why Warren Buffett support direct investment or index funds investment when compared to funds which are managed by famous fund managers
1. Every one of the managers of the underlying hedge funds had a huge financial incentive to do his or her best, which will bring down the net returns to a huge extend.
2. The huge fixed fees charged by all of the funds and funds-of-funds involved – fees that were totally unwarranted by performance – were such that their managers were showered with compensation over the nine years that have passed. As Gordon Gekko might have put it: “Fees never sleep.”
3. A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.
4. There are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees.
The bottom Line – Be An Active Investor
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. A lot of very smart people set out to do better than average in securities markets. Warren Buffett calls them active investors. He advises both large and small investors should stick with low-cost index funds.
Now think about your investment journey. Does mutual funds or direct investment or a low cost index fund have given more returns for you in the past 5 years..?