Buffett: Only handful of managers can really outperform

American investment guru Warren Buffett is on track to decisively win a 10-year bet that active managers cannot outperform the market.

Monday, February 27th 2017, 1:56PM

by Susan Edmunds

In Berkshire Hathaway's 2005 annual report, Buffett argued that active investment management, in aggregate, would always underperform the returns of passive funds.

"I 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," he said in this year's letter to shareholders.

"I 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. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line? What followed was the sound of silence."

He said only one man, Ted Seides, co-manager of Protege Partners, took the challenge.

Seides picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund.

The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager.

"Each fund-of-funds, of course, operated with a layer of fees that sat above the fees charged by the hedge funds in which it had invested. In this doubling-up arrangement, the larger fees were levied by the underlying hedge funds; each of the fund-of-funds imposed an additional fee for its presumed skills in selecting hedge-fund managers," Buffett said.

After nine years, the S&P index fund has gained 85.4%. The best performing of the funds of funds has returned 62.8%.

Buffett said the nine years had been relatively neutral - without the high returns that would have boosted an index fund or the drops that might have helped an active investor.

"In it, the five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000."

He described the returns for investors as "really dismal".

"And, alas, 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."

But, looking further afield, Buffett was optimistic about the future for investors.

He said American business was virtually certain to be worth more in future years.

"Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle."

He said investors needed to remember that widespread fear was their friend, because it helped deliver bargains. But personal fear was an enemy.

"Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well."

Buffett also extolled the virtues of migration. He said said the "miraculous" achievements of the US economy since its founding could be attributed in part to people who had the courage to leave their home countries for America.

"From a standing start 240 years ago - a span of time less than triple my days on earth - Americans have combined human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law to deliver abundance beyond any dreams of our forefathers," Buffett said.

Tags: Active v Passive