Average Manager Cannot Beat the Index - Buffett

Warren Buffett updated his bet against hedge fund managers and he is winning big

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May 11, 2016
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Warren Buffett (Trades, Portfolio) set aside time at last week's Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual meeting to explain, with a vivid illustration, exactly why investment managers on average do not and cannot beat the index. In fact, they must, on average and as a population, "tie" the index before costs and trail it after accounting for their fees.

To illustrate, Buffett (and I am paraphrasing here) asked his audience (an arena holding 18,000 people) to imagine that they collectively owned all the companies in America. In my explanation of Buffett's illustration, I will assume the companies are publicly traded although Buffett did not make that assumption.

The half of the audience on the right side of the arena would purchase their half of all these companies through a very low cost index fund that tracked the stocks and thereafter would hold their position indefinitely for, say, the next 50 years. (But the example works exactly the same whether it is 50 years or 50 days). Each audience member would not need to invest the same dollar amount, but this half of the audience would collectively purchase half of the total stock market value of all companies. They would therefore collectively receive exactly half of all the dividends paid by the companies. And they would collectively experience exactly half of the capital gains or losses in stock prices over any time period. Each member of this half of the audience would make exactly the same percentage return in any given time period. They would all make the index return, less whatever tiny cost the index fund imposed.

Meanwhile, the left-hand half of the audience would collectively invest an equal amount of money but would do so indirectly, with each person choosing an active manager who would invest for them. The managers would study which companies were likely to see stock prices rise fastest. Each manager would choose different companies and industries to concentrate on. They would use a variety of fundamental and technical analysis techniques to do this. At the end of the day, this half of the audience would alsocollectively receive precisely half of the dividends from the population of companies and would experience exactly half of the capital gains or losses each year, month, day, and hour of trading.

Some of these active managers and their investors would assuredly do better than others and better than the index average. But that could only come at the expense of some of the other active managers and their investors doing worse than average. It is a mathematical fact that this active side of the audience would collectively (though not individually) earn exactly the same returns before costs as the buy-and-hold-the-index side. But their investment management fees would be far higher and they would therefore collectively and on average trail the index and the index investors after costs.

This illustration and math should be sobering to all of us who deviate from a strategy of merely buying and holding the index. Most active investment managers might be inclined to disbelieve or deny the math and very few would ever point it out to clients. But at IWB we are highly ethical investment advisers and have no interest in hiding from this truth. I have pointed it out several times in the past on my own website.

Equity investors in aggregate and on average do make positive returns over time. Those returns are ultimately attributable entirely to the profits of companies. Over time, there is a flow of money from customers of companies to the owners of companies. Layered on top of that is trading activity, whereby some investors try to make higher than average returns. This trading-with-other-investors activity is undeniably a zero-sum game (and negative after costs). For one active investor to beat the index by a dollar, another active investor must trail by that dollar.

But it is also undeniable that some active investors will beat the index. Some investment managers will beat the index consistently. Buffett has often pointed out that a certain group of disciples of Benjamin Graham, including himself, went on to consistently beat the market for decades.

I certainly agree with Buffett's point that, given that the clients of active managers as a population will trail the index by whatever fees they pay, it becomes very important for those who choose active investment to look for low-fee approaches.

The subscribers to IWB have chosen to pursue an active investment style as opposed to only holding broad indexes of equities. Nothing in Buffett's message, or most certainly in his own approach, suggests that any particular active investor will fail to beat the index. He does warn however that the averageactive investor will fail to beat the index after costs and that paying higher fees makes such failure to beat the index more likely. A subscription to IWB combined with a discount brokerage account can result in a very low cost approach. And of course, at IWB we believe we are following rational methodologies that can beat the approaches of most other active investors.

Buffett also did not address the fact that many investment advisers provide services and benefits beyond attempting to beat the market. In fact, an increasing number of them do not seek to beat the index.

Benefits that investment advisers can provide over and above selecting equities include building risk-appropriate overall portfolios, consideration of income tax effects, education regarding the use of RRSPs and Tax-Free Savings Accounts, and the all-important encouragement and facilitation of regular monthly investment programs.

It is also true that even the average active manager will beat a particular index such as the S&P 500 in some time periods. That happens because managers do not restrict their investments only to stocks in the S&P 500 or to only companies traded in the United States. Compared against an index properly representing all of their investments, the average active manger, by definition, cannot beat the index. The requirement to choose a proper index raises the point that it is not that easy for investors to find and select such an index or group of indexes. Many investors require some form of advice even if they choose a purely passive buy-and-hold-the-index(es) strategy.

For more details regarding Buffett's thoughts about the folly of investors paying excessive fees for investment advice see his 2005 annual letter, which is available at berkshirehathaway.com. Look at the section titled "How to Minimize Investment Returns" starting at page 18.

Shawn Allen has been providing stock picks on his website at www.investorsfriend.com since the beginning of the year 2000 and has a great success record. He is based in Edmonton.