By the time you read this, Warren Buffett’s eagerly anticipated annual Berkshire Hathaway investor letter will be out, and investors of all types will be poring over it.
As normal, there won’t be any big bombshells in it. In fact, all signs leading up to the release points at Buffett discussing something which is fundamentally boring: passive trading.
He has been a strong proponent of it over the years, and recently he has been hinting at it being a big topic in the letter. He even went as far as revealing that when he passes, 90% of what is left for his wife will sit in Vanguard’s S&P 500 fund.
Here is the thing though. Warren Buffett is an active manager. Even more so than most of the active managers on Wall Street, considering he, or his Berkshire surrogates, take a role in managing the companies Berkshire purchases.
So essentially, any conversation is going to be a version of “do what I say, not what I do.” He is the antithesis of passive investment.
With this in mind, here is something you aren’t going to hear from Buffett regarding active management.
Active Management Isn’t All Bad…
By far the most compelling reason to avoid active management is that it consistently underperforms.
The S&P 500 puts out information on this through its biannual SPIVA Scorecard, and it is routinely depressing.
With data through June 30, 2016, the percentage of large-cap funds that underperformed the S&P 500 is: 84.62% over one year, 81.31% over three years, and 91.91% over five years.
And the winners rarely can maintain their performance. As S&P 500 research shows, less than 1% of large-cap funds and no mid-cap or small-cap funds managed to remain in the top quartile at the end of the five-year period.
No wonder passively managed funds attracted $1.8 trillion more than active funds over the last 10 years.
Check out this chart of total annualized returns from July 1994 to January 2017:
Index providers such as S&P, FTSE Russell, and MSCI have turned traditional styles of active management into indexes, and those indexes have historically beaten the market.
The MSCI USA Momentum Index and the MSCI USA Quality Index stand out, with the former outperforming the S&P 500 by 3.2% annually, while the latter beat it by 2%, from July 1994 through January of this year.
Similar strategies have done well in emerging markets as well, though you’ll see far more variability in year-to-year results.
…but Active Managers Are
So not all active management techniques, especially more traditional ones, are bad. In fact, some are very consistently good.
So why the discrepancy between the S&P 500’s SPIVA Scorecard data and a very basic look at popular indices?
There is an easy answer there — the profits are being skimmed off before they can bolster actual portfolio performance.
The C class shares that we have access to through mutual funds come with an average 2% a year, eating most outperformance in the best of years, and driving results far below the broader market the rest of the time.
So of course $1.8 trillion more went into passive funds over 10 years. On any realistic investing timeline, extremely low fees deliver a decisive advantage.
There are now 46 passive funds with fees under 0.1% these days, and the pressure is on active managers to drive down fees.
Except where it is not.
The vast majority of those ETFs exclusively contain the cheapest stocks in the world to trade — U.S. large-cap stocks.
Few portfolios are invested solely in U.S. large-cap stocks, and for good reason. Diversification across sectors, international and small-cap exposure for higher returns and growth rates, and ownership of different asset types, such as bonds and precious metals, is required for any degree of balance.
Some of this, especially small investor access to different investment techniques, like value and momentum, and different investment types, like small-cap and international shares, will never be as cheap as the ultra-low-cost ETFs that seem to have become the fee benchmark for many.
The Whole Picture
The pressure may be on fees and active managers, but they aren’t going anywhere soon.
Many of us won’t be able to break away from them due to fund restrictions in our retirement accounts, which guarantees a very large amount of active management in the market no matter what individual investors may prefer.
While Buffett may extol the virtues of passive investment, and may pledge to put 90% of the wealth he leaves to his wife when he dies in the Vanguard S&P 500 fund, most of us are going to have to live with a certain degree of active management in our portfolio.
However, that doesn’t mean we have to live with mediocre performance and high fees. Do your research and talk to HR about different retirement options for your company. Ask them to shop around, and show them how your retirement fund managers are doing in comparison.
Most of them have no idea what is going on, and sign off on whatever their predecessor signed off on when they, in turn, had no idea what was going on.
And on the individual level, utilize low-cost total index and large-cap funds as much as you can. Live with higher fees for investment types that you can’t easily manage yourself, like emerging market equities and bonds.
Buffett is right about passive investing. It is a wonderful thing. But don’t take it to the extreme.
Buffett has done as well as he has because he took the active management role in his own portfolio. If he passively invested at Berkshire, he’d only have returned about one-eighth of what he did over the last 30 years.
So yes, use passive investing where it is appropriate, just remember the difference between what Buffett says and what he does.
