“Both large and small investors should stick with low-cost index funds,” according to Berkshire Hathaway Chairman Warren Buffett. In his annual shareholder letter, the Oracle of Omaha reminded investors something they probably know intuitively, “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.” This is not a new message for Buffett. Three years ago, he provided similar advice to the trustees of his estate: “Put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund…I believe the trust's long-term results from this policy will be superior to those attained by most investors…who employ high-fee managers.”
Buffett has long held that most investors are better off with low-cost index funds than paying higher fees to managers, especially hedge fund managers, who often underperform the index over the short and long term time horizons. Nearly a decade ago, Buffett put his money where his passive investing heart and mouth were: he challenged any active manager to beat the S&P 500 index with a portfolio of hedge funds. Buffett said that he would put up $500,000 to test his theory. The other side would also be required to wager the same amount in what would become “The Million-Dollar Bet.”
According to Buffett, only one person had the guts to take the bet: Ted Seides, a co-manager of Protégé Partners, which invests in a variety of hedge funds for his clients. We should have known that Siedes had an uphill battle, because performance would be measured net of fees, costs and expenses. At the time of the bet, most hedge funds carried fees of two percent annually plus twenty percent of the upside appreciation. That’s a pretty big gap to cover, when compared to an index fund, which costs less than 0.20 percent annually.
With the bet now in its tenth and final year, how is each side doing? Through 2016, the compounded annual increase for the index fund is 7.1 percent versus 2.2 percent for the five handpicked hedge funds. As Buffett noted, “that means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000.”
Investors have come a long way toward embracing the Buffett-endorsed index fund approach to investing. According to Morningstar, investors fired a number of their U.S.-based active managers, pulling a net $342.4 billion from their funds last year. Those proceeds, plus new money that was invested, amounted to a record $505.6 billion into U.S.-based passively managed funds. That trend is expected to continue. Although currently just a third of invested assets are held in passive index and exchange traded funds, ratings agency Moody’s projects that the passive side of the business will become dominant by 2024.
The hedge fund industry has tried to compete by lowering fees to induce pension funds and wealthy individuals to stay the course. This year, the average hedge fund will charge a 1.49 percent management fee and 17.5 percent performance fee. Slashing fees to expensive from obscene is unlikely to change the outcome of the passive versus active debate.
Yet, whenever I extol the virtues of passive investing, there are still those who like to tell me that there are some situations when an active fund will beat the index. That may be true, but spending the time and energy to find that one fund or manager may not be worth the trouble. As Buffett notes, the search for superior investment advice has caused investors “to waste more than $100 billion over the past decade.”