Warren Buffett On Passive Index Investing

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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.


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Vern Gowdie

Vern Gowdie

Editor at Markets & Money

Vern Gowdie has been involved in financial planning in Australia 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 magazine as one of the top five financial planning firms in Australia.

He is a feature editor to Markets and Money and is Founder and Chairman of the Gowdie Family Wealth and the Gowdie Letter advisory services.

Vern Gowdie

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3 Comments on "Warren Buffett On Passive Index Investing"

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Mark Tomarket

Some good thoughts here, particularly in relation to vested interests protecting their patch. But at this juncture how does passive index investing sit with your suggestions of a 90% hit to equities over the next few years? Is it a strategy for market re-entry later down the track? Cheers

slewie the pi-rat
from what i see in the US, the winner here would be: “Perhaps it is due to 80% of planners being tied to or employed by fund management companies.” after all, what are fiduciaries for? i actually had someone tell me recently: i bought an annuity but they paid the commission to my financial adviser, so the commission didn’t cost me anything! i was so happy for her that my tongue bled for a whole day from biting it, on that one… of course, timing is STILL ‘everything’ and if one gets caught buying the top of anything, long-term, it… Read more »
Jon B

I think Vern’s interpretation is contextually limited to suit his own view of the world (much like an active fund manager). What Mr Buffet is saying “if you think it’s simple, you are stupid”.

I share both Warren’s and Vern’s dim view of the quality of most portfolio management, but Warren invests actively, and always has, and probably wants avoid his out performance being frittered away by someone he doesn’t know. Also presumedly the beneficiaries of his estate will receive Berkshire Hathaway Stock which he knows is actively managed.


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