Forever Investor

One of the most interesting parts of the Berkshire Hatahway AGM this year was the update on the Buffett vs Protégé Partners bet. For anyone who doesn’t know the background, here is the bet:

Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.

So far, Buffett is being proved correct–the latest score is S&P +43.8%, Protégé +12.5%.

Buffett’s argument is, essentially, that the large number of active managers buying this, that, and the other will, in aggregate, get an average return. Passive investors, buying cheap index tracking funds that do not attempt to beat the index, will also get the average market return. The difference between the two approaches (active vs passive) is simply the fees that you pay. Passive investors pay a low fraction of a percent while investors in actively managed funds will pay anything from 1% to 2%+. This percent or two, compounded over time, virtually ensures that the passive investor will do better.

The particular subset of active management Buffett is betting against here is a fund of hedge funds, that is, a fund that invests in other hedge funds. Hedge funds, traditionally, charge higher fees than regular funds (unit trusts or mutual funds): 2% of capital plus 20% of any profits that exceed a pre-agreed benchmark is not unusual. A fund of hedge funds introduces another level of fees–in addition to the fees paid to the hedge fund managers that actually invest the money, another layer of fees must be paid to the expert who picks the hedge funds. It is like going to play roulette, but rather than pick red or black yourself, you pay an expert to pick red or black on your behalf every time you want to place a bet. Funds of hedge funds are usually the most expensive form of active management on the market.

There are other factors too, in addition to fees, that make it extremely difficult for actively managed funds to outperform the index consistently over time. Three that immediately spring to mind are:

• Funds that do well, and provide above average returns, attract attention and more money. These increasing inflows make it more difficult to invest nimbly and in small companies, which tend to provide the greater returns and differential potential. These factors result in, by necessity, more conventional investments. More conventional investments result in more conventional returns at which point those fees begin to weigh more heavily. This is the anchor.
• Funds that do badly, even when that is due to a general market fall, tend to suffer withdrawals as disillusioned investors decide that they want their money back to turn it into cash and either stash under the mattress or put it into a different fund with which they have become more enamoured. This forces active managers to sell after price falls, which is of course precisely the time that they should be buying. The increased trading activity, in addition to being the wrong sort (selling) at the wrong time (after market falls) also results in further costs and fees. This is the downward spiral.
• Most investors are too cautious to invest in funds that do not contain a lot of individual positions. This encourages fund managers to take a large number of positions, which dilutes their best ideas to such an extent that they finish up with what is, in effect, often just an index tracker with a difference. The difference? Fees. The anchor again…

It is difficult to believe the difference that 1%, never mind 2%, can make to your total return when this charge is compounded over time. If you are dubious, then take a look at some figures given by John Bogle (the man behind Vanguard, the original index fund provider), in his Common Sense on Mutual Funds, p. 181.

Initial Investment of $10,000:

*Lost capital as percentage of market appreciation

These figures show why John Bogle says that, over an investing lifetime, fund expenses come to account for 35% of total return. 1% may not sound like much, but it is like running a marathon with weights tied around your ankles–you can’t win.