I recently read Warren Buffett’s most recent shareholder letter and I must admit it was my favorite. Though nobody calls me the “Oracle of Illinois,” I couldn’t help but feel like Warren was articulating the same investment wisdom I’ve been promoting on my radio show for the past 25 years.
The good part and the bad part of having a radio show (Paul Ruedi’s On-The-Money on WDWS AM 1400 / 2nd and 4th Tuesday of each month at 10:00 A.M.) is your record is public. That is, my track record is on display. My listeners can all vouch that over my decades on the radio my message has remained consistent and contained several recurring themes and ideas.
Mr. Buffett echoed a lot of those ideas in his most recent letter to shareholders. To those of you who listen to my show regularly, prepare to hear what you have been hearing from me for 25 years, though eloquently put by one of the world’s greatest investors.
“Beating the Market” is Difficult, Even for the Professionals.
In 1992, at a fairly young age, I discovered active management and trying to “beat the market” was a losing proposition for several reasons and began to utilize passively managed index mutual funds for my client portfolios for the next 25 years.
Mr. Buffett seems to agree with me that beating the market is hard to do. But he put his money where his mouth is in a different way when he made a bet in 2008 with hedge fund magnate Ted Seides, who is the co-founder of Protégé Partners…“an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds.”
“Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager. Each fund-of-funds, of course, operated with a layer of fees that sat above the fees charged by the hedge funds in which it had invested. In this doubling-up arrangement, the larger fees were levied by the underlying hedge funds; each of the fund-of-funds imposed an additional fee for its presumed skills in selecting hedge-fund managers.”
We have less than a year to go until the bet is finished, but the index fund is far enough ahead to begin assuming victory. Mr. Buffett, rubbing it in a bit writes, “Here are the results for the first nine years of the bet – figures leaving no doubt that Girls Inc. of Omaha, the charitable beneficiary I designated to get any bet winnings I earned, will be the organization eagerly opening the mail next January.”
Mr. Buffett summarizes the shellacking: “$1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000…Bear in mind that every one of the 100-plus managers of the underlying hedge funds had a huge financial incentive to do his or her best. Moreover, the five funds-of-funds managers that Ted selected were similarly incentivized to select the best hedge-fund managers possible because the five were entitled to performance fees based on the results of the underlying funds.”
He went on to explain much of the difference could be pointed at very high fees the hedge funds charge their investors, with as much as “60%-gulp!—of all gains achieved by the five funds-of-funds were diverted to the two levels of managers. That was their misbegotten reward for accomplishing something far short of what their many hundreds of limited partners could have effortlessly – and with virtually no cost – achieved on their own.”
These were supposed to be the best of the best of active managers. They had every incentive to perform better than the market. They couldn’t even come close. But they still earned plenty of fees.
Over the years, I have been asked many times about hedge funds. My opinion has been consistent, “hedge funds are actively managed mutual funds for rich idiots.” It appears that Mr. Buffett might just be suggesting the same thing, but I do not want to put words in his mouth.
Picking Winning Managers is a Fool’s Errand
In my experience, too many investors will look at all the evidence that points to the failure of active management and still, for some odd reason, believe that they can pick a winning manager. Warren and I both agree that is much more difficult than people make it sound.
I think that is what Mr. Buffett is suggesting when he writes, “The job, after all, is not impossible. The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.”
I am on record, time and time again telling anyone who would listen that they are just fooling themselves if they think they have the ability to find superior managers. No matter what methods they use, there is simply too much noise in the data to allow people, even the experts, to distinguish between skill and luck. I am not saying that there are not some managers that can beat the market, it’s just that regardless of investors’ selection skills, they are most likely picking a manager at random, which means they should expect to lose.
Mr. Buffett explains it well: “Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.”
For more than 25 years, whether in my newsletters or on my radio show, I have discussed what makes the job of hiring superior managers so difficult, and not worth pursuing. The vast majority will fail to deliver the market-beating performance they promise, and distinguishing true skill from dumb luck is incredibly hard to do. It is interesting to have such strong agreement on the matter from someone who is considered an extremely skilled investor.
The Issues with Chasing Skill
Suppose there are managers out there that do actually possess investing skill. It surely won’t go unnoticed for more than a few minutes, and money, being thoroughly liquid and substitutable, will chase those returns with a tsunami of new investment. This ends up diluting the manager’s expertise over a much larger asset base until it effectively disappears.
Mr. Buffett seems to recognize this problem himself, as he brings up in his newsletter: “Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees.”
Time and time again I have counseled investors that even if you could identify skilled managers it would be irrelevant because any additional benefit to be gained by investing with them gets totally blown away by the activities of other investors racing with them to take advantage of these superior managers.
The Incurable Optimist
Over the years, many of my clients and radio show listeners have labeled me an “incurable optimist.” I have always emphasized that optimism is the only world view to square with the facts.
Warren takes a similar stance when he opined about “America’s economic dynamism”, and the one word that sums it all up, “miraculous.” He writes, “You need not be an economist to understand how well our system has worked. Just look around you. See the 75 million owner-occupied homes, the bountiful farmland, the 260 million vehicles, the hyper-productive factories, the great medical centers, the talent-filled universities, you name it – they all represent a net gain for Americans from the barren lands, primitive structures and meager output of 1776. Starting from scratch, America has amassed wealth totaling $90 trillion.”
He goes on to write, “American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that. Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle” he writes.
Does this incurable optimism sound familiar to anyone? But I always provide this optimism with some extra words of caution and perspective: the permanent uptrend in stocks will not be without temporary declines along the way, but you know this in advance and it shouldn’t deter you from investing or being optimistic. Mr. Buffett, while using different phraseology, essentially says the same thing when he writes, “Yes, the build-up of wealth will be interrupted for short periods from time to time. It will not, however, be stopped. I’ll repeat what I’ve both said in the past and expect to say in future years: Babies born in America today are the luckiest crop in history.”
I enjoy the annual letters from Mr. Buffett, who many claim to be the world’s greatest investor. When I read his most recent words and recognized them as ideas I have been writing and speaking about for more than three decades well before they were popular, I was even more pleased. Mr. Buffett is the poster child for skilled active management, but he agrees with me that in the aggregate active investing is likely to disappoint and people would be better off just passively owning the market using an index fund. He also shares the same optimistic outlook for the future firmly based on the record of history. That Warren and I arrive at these same conclusions despite different philosophical backgrounds and completely different careers indicates that these may be some of the fundamental truths of investing. Wise investors should take note.
Quotes are taken from Warren Buffett’s 2016 Berkshire Hathaway Shareholder Letter
Disclaimer: Past performance is not indicative of future results.