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Lessons from America’s most admired investor: Warren Buffett

Should you mirror Buffett's bet to beat the market consistently over long stretches of time?


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Should the University of Colorado Foundation change and simplify the investment policy for the management of CU's endowment by switching to passively managed portfolios?

Should Colorado PERA do the same on behalf of the state's public employees for whom it manages retirement assets?

According to the NACUBO-Commonfund Study of Endowments for the most recent fiscal year-end – June 30, 2016 – (which included m ore than 800 college endowments, representing $515 billion in assets), the overall results are: unsurprisingly poor.

In the table below, we compare the annual returns of a "Bogle Model" – a portfolio constructed with three Vanguard index funds with a total annual cost of 0.07 percent. (Total U.S. Stock Market Index Fund (40 percent), Total International Stock Market Index Fund (20 percent), and total Bond Market Index Fund (40 percent) to the NACUBO endowment returns during three-, five- and 10-year periods.

"Over a ten-year period commencing on Jan. 1, 2008 and ending Dec. 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.

A lot of very smart people set out to do better than average in securities markets. Call them active investors.

Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore, the balance of the universe – the active investors – must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors. 

Costs skyrocket when large annual fees, larger performance fees, and active trading costs are all added to the active investor's equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested.

A number of smart people are involved in running hedge funds. But to a greater extent their efforts are self-neutralizing, and their IQs will not overcome the costs they impost on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds."

 

After a long period of silence, someone finally accepted Buffett's $1 million wager: Ted Seides, a co-manager of Protégé Partners. Protégé is a fund of funds and Seides selected five funds of funds for his side of the bet to compete against an S&P 500 index fund.

 

Here are the results for the first nine years of the 10-year bet:

 

During these nine years, the 85.4 percent cumulative return of the S&P 500 index was equivalent to a 7.1 percent compounded rate of return – even with the horrific -37 percent return in 2008, when each fund of funds did comparatively better, but still experienced losses. During the same nine-year period (through 2016), the average of the five funds of funds delivered a compounded annual return of only 2.2 percent.

 

In dollar terms, $1 million invested in the funds would have gained $220,000, compared to a gain of $854,000 in the index fund – a differential of 288 percent. By way of explanation, here are a few select quotes from Buffett's 2017 letter; consider these timeless lessons from America's most admired investor:

 

"There are, of course, some skilled individuals who are likely to out-perform the S&P over long stretches. In my lifetime, though I've identified — early on — only 10 or so professionals that I expected would accomplish this feat. There are, no doubt, many hundreds of people – perhaps thousands – whom I have never met and whose abilities would equal those of the people I've identified. 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. Over the years, I've often been asked for investment advice, and in the process of answering I've learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion. I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I've given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helped called a consultant.

 

In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial "elites" – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is – on an expectancy basis – clearly the best choice. My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Human behavior won't change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something 'extra' in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion will be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: 'When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.'"

 

Warren Buffett is one of those rare, gifted individuals who consistently outperforms the market. He's an extreme outlier – probably the greatest investor of all time. In fact, his outperformance is just silly. 

 

During the 52 years that Buffett has been managing Berkshire (1965-2016), the compounded annual rate of return of Berkshire's book value and market have been 19 percent and 20.8 percent, respectively, compared to the S&P 500's 9.7 percent compounded annual gain. On an aggregate basis, the returns are an 884,319 percent increase in a book value and a 1,972,595 percent increase in market value, compared to a mere 12,717 percent increase for the S&P 500 index (total return, including dividends).

 

There are others with admirable term-records of outperformance: John Templeton, Peter Lynch and Seth Klarman, to name a few. And there are pockets of inefficiency and anomalies that can be exploited by niche strategies and nimble managers.

 

So beating the market consistently over long time periods is possible, but also exceedingly difficult and therefore improbable.

 

BEHAVIORAL TAKEAWAY

 

Leon Festinger's 1957 theory of cognitive dissonance focuses on how human beings strive for internal consistency. Cognitive dissonance is the mental stress or discomfort experienced by a person who simultaneously holds two or more contradictory beliefs, ideas or values. Despite overwhelming logical and empirical evidence as to why active management in the aggregate must always underperform passive management on an after-fee basis (as, in fact, it has) many investors – particularly those of the institutional variety – act in a manner that is inconsistent with their intelligence.

 

Don't take the bait.

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