The biggest event for budding value investors is the day Warren Buffett releases his annual letter to shareholders. Berkshire Hathaway (BRK.A, BRK.B) reported annual results over the weekend and Warren Buffett released his missive to investors, discussing a variety of topics germane to the firm as well as several broader topics.
The point to get the most media coverage was Buffett’s attack on fees. Here’s the big quote:
“I’m certain that in almost all cases the managers at both levels were honest and intelligent people. But the results for their investors were dismal – really dismal. And, alas, the huge fixed fees charged by all of the funds and funds-of-funds involved – fees that were totally unwarranted by performance – were such that their managers were showered with compensation over the nine years that have passed. As Gordon Gekko might have put it: “Fees never sleep.”
What is the context of this comment? About 10 years ago, Buffett bet active investment firm Protege Partners that a passive index fund would beat a group of funds that Protege Partners selected. The bet began in 2007 and is set to end at the end of this year. So far, the passive fund is up 85.4% and the chosen funds are up 22%. Assuming there’s no market collapse, Buffett will clearly win.
For the financial press and Buffett, this is proof that management fees cause active investment to underperform.
Buffett goes on to note that the 2 and 20 rule of hedge funds profits these actively managed firms in cases where they simply pile up assets under management, regardless of performance.
“Under this lopsided arrangement, a hedge fund operator’s ability to simply pile up assets under management has made many of these managers extraordinarily rich, even as their investments have performed poorly.”
That leaves open the question of how a hedge fund can attract investors when it performs poorly, and it’s a question Buffett never answers. Additionally, Buffett notes that the fees of the underlying fund aren’t the only problem—since Protege chose “fund of funds”, we have the problem of compounded fees.
“Remember, there were the fund-of-funds managers to be fed as well. These managers received an additional fixed amount that was usually set at 1% of assets. Then, despite the terrible overall record of the five funds-of-funds, some experienced a few good years and collected “performance” fees. Consequently, I estimate that over the nine-year period roughly 60% – gulp! – of all gains achieved by the five funds-of-funds were diverted to the two levels of managers.”
This has quickly been used as a rallying cry for passive investment and against actively managing funds. As a retail investor, you are probably better off just using a low-cost index fund and not worrying about stock picking for the rest of your life.
For the majority of middle class Americans, this is undoubtedly true. However, the financial press is taking this a step too far to say that this proves active money management will never work, the efficient market hypothesis is correct, and no one will ever beat the market.
This is wrong.
The first bit of evidence to prove this wrong would be Warren Buffett himself, who, after all, carefully picks stocks and actively manages funds in Berkshire Hathaway. Secondly, Buffett himself would disagree with the logic leap that many people take here.
“There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat,” Buffett writes immediately after attacking high fees. In other words, Buffett isn’t saying that active money management is always a bad thing, but that it is very difficult to do and very few people can do it.
Let’s read further. “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.”
In other words, you need to be very selective when choosing someone to actively manage your money. Money management is very hard, market-beating returns are very hard to make over the long term. Buffett quotes Bill Ruane to make his point: “In investment management, the progression is from the innovators to the imitators to the swarming incompetents.”
It seems that Buffett isn’t attacking active money management as much as he is attacking incompetent active money management. He’s criticizing funds that underdeliver on their promises and charge high fees while doing so. It’s quite a leap to say that all active money managers are incompetent, and Buffett himself does not actually say this. However, that is precisely how he is being interpreted by the mainstream press.
Buffett’s hope in making this bet is to force Wall Street to clean up its act, slim down, and become more efficient. Wall Street has been doing that for nearly a decade, and will probably continue to do so at an accelerated pace. However, Buffett’s bet will also have the unfortunate side effect of convincing more people that taking an active role in managing your life savings will be a bad thing. At the extreme, this may cause ill-informed people to keep their net worth in a 0% yielding savings account.
If nothing else, this situation is a very good lesson in why a little knowledge is a bad thing.