Sometimes you just can’t enjoy your day in the sun.
You see, I was basking in the afterglow of having published Part 3 of my How I Invest series when I randomly received a letter from my company’s 401k advisor — let’s call her Christy. At the outset, I must admit that I have a difficult relationship with Christy. I like her a lot personally. However, I am not a fan of active management, I don’t like trading individual stocks, and I loathe the high fees charged by commercial brokers. You could say that my quarterly meetings with Christy are very tense at times as we debate the merits of passive vs. active management. Sounds exciting doesn’t it?
Anyway, I couldn’t believe Christy’s unfortunate timing. I had just finished waxing eloquently about the many virtues of index fund investing. I espoused worldwide asset class diversification and demonstrated how a well-diversified, buy-and-hold portfolio beats the Total U.S. Stock Market Index fund in various categories, including:
- Compound Annual Growth Rate (CAGR)
- Standard Deviation (i.e. Risk)
- Deepest Drawdown (maximum drop since 1970)
- Longest Drawdown (length of recovery period)
- Safe Withdrawal Rate in retirement
When I opened the envelope I was surprised to find that, instead of a form letter, Christy had personally hand folded a newspaper clipping and placed it in the mail just for me. As soon as I opened the envelope I laughed out loud! Christy had sent me an article making the case for active management and warning investors about the bleak near future for index fund investing. I guess Christy figured that a third-party “guru” from a major publication would change my stubborn mind where she had failed …. repeatedly. You see, I personally choose all of the investments in my 401k much to Christy’s chagrin. In any event, the article made the following main points:
- The year 2016 was terrible for active managers as investors “yanked billions” from active funds and invested in index funds (Sounds great so far!)
- The market has peaked and it’s time for active managers to shine because they “outperform at market turns” (And just how do they know when the market has turned??)
- Index funds investing is getting overpopulated (??)
- Index fund investors must guess when the market is rising and falling so they can get in and out (who said anything about getting in and out? We’re not market timers!)
- Index fund investors “sacrifice due diligence and outsource their investment decision-making process to the [S&P 500] index committee.” (No, we are well-informed, but happily accept the market returns without the high expenses and failures of active managers.)
- “Autopilot works fine when you’re climbing to cruising altitude, but you might want a skilled pilot when the descent starts”. (Again, who on Wall Street can accurately tell us when the descent is going to happen??)
I was not about to let Christy kill my buzz. Instead, I quickly pulled up Warren Buffett’s February 25, 2017 Berkshire Hathaway shareholder letter, attached it to an email, and hit the ball back across the net. I even directed her to page 21 of the letter, entitled The Bet (or how your money finds its way to Wall Street). I figured if she was going to pull out the big guns so would I. And who is more universally respected than the “Oracle of Omaha” himself? By the way, if you’re on the active vs. passive management proverbial fence, I urge you to take the time to read this section of Warren Buffett’s letter. But in case you don’t have time, I’ll summarize it.
First, Buffett explains that as far back as his 2005 annual shareholder 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.” As basis, 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.”
Buffett felt so strongly about his position on index funds that he publicly offered to wager $500,000 that no investment pro could pick a set of at least five hedge funds — “wildly-popular and high-fee investing vehicles” — that would match the performance of an unmanaged S&P-500 index fund charging only “token fees”. He suggested a ten-year bet and named a low-cost Vanguard S&P fund as his “contender”.
Buffet was shocked when only one such fund manager stepped up to the challenge. “After all,” he reasoned, “these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?” Buffett’s opponent selected five funds-of-funds that invested their money with more than 100 of Wall Street’s top hedge funds.
The results? After 9 years, Buffett is winning with a compound annual growth rate of 7.1% for his S&P index fund versus only 2.2% for his opponent! Explaining his results, Buffett shared the following formula:
If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win. . . . And if Group A has exorbitant costs, its shortfall will be substantial.
Although Buffett acknowledged that there are some “skilled individuals” who are highly likely to out-perform the S&P over long stretches, in his lifetime he has only identified ten or so professionals that he expected to accomplish this feat. As he sees it, “[t]he problem simply is that the great majority of managers who attempt to over-perform will fail.” Moreover, “[t]he probability is also very high that the person soliciting your funds will not be the exception who does well.” Buffett’s bottom line: “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. Both large and small investors should stick with low-cost index funds.”
I couldn’t agree more … Christy!!
I can’t wait to hear back from Christy. I’ll let you know if I convert her. Given that her livelihood is based upon active trading and high fees, I’m not holding my breath.
Have a great weekend everyone! I look forward to your comments.