Warren Buffett On Passive Index Investing

Warren Buffett’s latest shareholder letter provided an insight into his personal advice to the trustee of his will in relation to the bequest to his wife:

‘Put 10% of the cash in short-term government bonds and 90% 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…whether pension funds, institutions, or individuals who employ high-fee managers.’

It’s interesting to see the Oracle recommending his wife’s bequest for the 90% share asset allocation be entirely invested in an Index Fund.

Here is one of, if not the best active investment manager in the world giving a ringing endorsement to the merits of passive index investing.

The following chart of the percentage of US Equity (share) funds which outperformed their relative Index (courtesy of Business Insider) shows you clearly why Buffett would have formed this view.

click to enlarge

A quick look in the five year column shows something like 70% to 80% of managers FAILED to outperform their relative index. These are appalling statistics for what is termed the MANAGED fund industry.

The majority of investors are paying fees for sub-standard results. Which is why Buffett said:

‘…long-term results from this policy will be superior to those attained by most investors…’

Buffett also went on to state (emphasis mine): ‘Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit.’

With this comment Buffett takes a swipe at Wall Street and the investment industry in general. Clipping the ticket on transactions is the name of the game — irrespective of whether those transactions succeed or fail.

Recent data on the large number of recent underwater IPOs is evidence of the investment banking culture Buffett criticises.

Passive investing is to the investment industry what a vegan is to a butcher.

Previously I’ve mentioned the need to reduce the friction in your portfolio, especially in a low return environment.

When you consider the fee differential between index versus active management AND then add in the very real possibility of underperforming by three or more percent, it becomes a very expensive exercise.

Buffett’s choice of an index fund as the preferred investment vehicle for his wife’s inheritance is, I assume, the same conclusion I came to — with an 80% chance of underperforming, why bother paying excessively for these lousy odds?

These are the facts the investment industry will not share with you…for obvious reasons.

Knowing this information makes you wonder why the managed fund industry (in all its guises — superannuation, hedge funds, managed funds, etc) continues to prosper. Perhaps it is the prospect of an investor being one of the lucky ones investing in the 20% of future outperformers.

Perhaps it is the expensive marketing campaigns. Perhaps it is due to 80% of planners being tied to or employed by fund management companies.

Whatever the reasons, the funds under management data clearly indicates that the industry is flourishing.

There are very few guarantees in the investing world. But I am willing to guarantee Buffett’s advice on the merits of index investing will not feature anytime soon in the managed fund industry’s marketing efforts.


Vern Gowdie+
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Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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