Every year, Warren Buffett releases his highly-anticipated shareholder letter in which he not only speaks on the progress of Berkshire Hathaway in the previous year, but also offers some tidbits of wisdom and a glimpse into his mental process. It’s always an interesting read and both investors and businesspeople alike could stand to learn a lot from them.
In Buffett’s 2016 letter, however, he said something that has the investing world scratching their heads. In the letter, he spends a good deal of time arguing that passive managing is better than active managing. He actually encourages people to invest not in hedge funds or in their own ideas, but instead to use an index fund for the most security.
There are three interesting things about this sentiment. First, that Buffett is on the verge of winning an ongoing bet that a Vanguard index fund could outperform a selection of five hedge funds over the course of 10 years. You can read about it here, but the gist is that Buffett’s pick is up 65.7% while the hedge fund is languishing behind at 21.9%. Second, that Buffett himself is the world’s premier active manager. Although he doesn’t buy stocks for a quick profit, that doesn’t mean that he doesn’t ever sell them either. And third, that through his active managing style Buffett has consistently outperformed the S&P 500 for years.
So, with all that in mind, why does Buffett spend a good portion of his letter condemning active managers? Despite what you might read on other sites, it seems unlikely that Buffett is trying to wage a personal war against something that he’s actually uniquely good at. Nor is he the type to put down others so he looks good in comparison; because, let’s face it, no one can measure up to Buffett’s stock market game. Instead, what seems more likely is that Buffett isn’t actually completely against active managing of your portfolio–he’s against the huge fees that such managers tend to charge. It’s a small distinction, but an important one.
Here’s how Buffett explained it:
“The problem simply is that the great majority of managers who attempt to over-perform will fail… 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.”
It might seem a little harsh, but Buffett has a point in that no one can really predict the daily market fluctuations with any kind of accuracy. Fund managers, however, will try and will charge quite a few fees in the process, regardless as to whether their predictions turned out correct or not. This leads Buffett to the most logical conclusion: that index funds are less risky and less expensive, with just as much chance for profit and less fees (which makes the profit margin actually higher). So Buffett isn’t against active managing–he’s against paying someone a high fee for something that is essentially guesswork.