Monday, September 12, 2016

Buffett on Active Investing

Warren Buffett said the following on CNBC back in May:

"Active investing as a whole is certain to lead to worse than average results."

He goes on to explain that those who are active, in aggregate, must by definition get an average result. Subtract all the fees and what happens is a below average result. John Bogle has previously made the point that it's tough to get around what he calls the "relentless rules of humble arithmetic".

Naturally some think they themselves will be able to outperform over the long haul or, alternatively, that they'll be able to reliably pick, beforehand, an active manager who will outperform.

This might prove possible for some but history shows it's much easier in theory than reality.

Buffett's bet with Protege Partners -- one that now goes back more than eight years -- was, from his point of view, meant to demonstrate that while many "smart people are involved in running hedge funds...to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors."

Naturally, Protege held the opposite view.

The results so far?*

Index Fund: 65.7%
Hedge Funds: 21.9%

Of course, one example doesn't necessarily prove anything but Buffett elaborated on his thinking during the 2016 Berkshire Hathaway (BRKa) shareholder meeting:

"Supposedly sophisticated people...hire consultants, and no consultant in the world is going to tell you 'just buy an S&P index fund and sit for the next 50 years.' You don't get to be a consultant that way. And you certainly don't get an annual fee that way. So the consultant has every motivation in the world to tell you, 'this year I think we should concentrate more on international stocks,' or 'this manager is particularly good on the short side,' and so they come in and they talk for hours, and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in the American business without cost. And then those consultants, after they get their fees, they in turn recommend to you other people who charge fees, which... cumulatively eat up capital like crazy."

And, according to Buffett, it's not easy to change behavior:

"I've talked to huge pension funds, and I've taken them through the math, and when I leave, they go out and hire a bunch of consultants and pay them a lot of money. It's just unbelievable."

And guess who these consultants tend to recommend?

Hedge funds that typically get paid via something like a 2-and-20 or a similar compensation structure.

According to Buffett these consultants usually "have lots of charts and PowerPoint presentations and they recommend people who are in turn going to charge a lot of money and they say, 'well you can only get the best talent by paying 2-and-20,' or something of the sort, and the flow of money from the 'hyperactive' to what I call the 'helpers' is dramatic."

During the CNBC interview Buffett added the following:

"In...almost every field, the professional brings something to the party."

Yet, in contrast, Buffett points out that the world of professional investing as a whole produces "negative results to their clientele. And that's a very interesting phenomenon to live with, if you spend your life doing something where your expectancy is to hurt your customer. And yet that is the case for professional investors."

Naturally, some capable individual managers will outperform. Yet as Charlie Munger said at the Berkshire meeting:

"There have been a few of these managers who've actually succeeded...But it's a tiny group of people...like looking for a needle in a haystack."

Think about it this way: if 80% to 90% of actively managed funds tend to underperform, then that by definition means the purchaser of a low-cost index fund, with no skills whatsoever, should over the long-term outperform roughly 80% to 90% of the professional managers.**

Can you imagine such a product existing for other professions?

In other words, there's just no way to buy a product that will enable someone to perform better than, for example, 80% to 90% of doctors without the requisite expertise. The same would be mostly true for other professions (and, for that matter, this also applies to skilled trades).

Of course, one of the problems with this is investors tend to trade index funds too much -- the net reward for the incremental effort being reduced returns -- as well as the actively managed funds they own. Such behavior usually turns what should be inherently, at least on a relative basis, an advantageous approach into one that is less so.

It's tough to outperform picking individual stocks. Similarly, it's tough to pick the professional investors who, going forward and over the long-term, will not only outperform, but will outperform by enough to justify all the frictional costs and, possibly, the incremental risks they'll need to take.

Stocks, generally speaking, appear to be not all cheap these days. So it would seem to be rather unwise to expect market averages will produce more than modest results as long as such valuations persist. Of course, what look like high-ish valuations can for a time become even higher and, as far as near-term price action goes, almost anything can happen.***

Some will see such a situation for what it is and no doubt be tempted to find some creative ways to outperform.

An understandable response?

Possibly.

That doesn't necessarily make it the correct response.

The vast majority (I'd 80% to 90% qualifies) of  active investors -- many who are smart, capable, and hardworking -- do worse than what a passive approach could achieve. So that means many market participants, if nothing else, must have a built in bias; they inherently overestimate their own likelihood of success. To them, it's always the other less prepared and less able participants who'll do worse than the average.

Certainly not themselves.

It's worth amplifying that all the extra effort involved isn't just producing no incremental benefit, it's producing a worse than passive outcome; a negative return on all the additional invested time and effort.

A subpar result for the investors though likely not for the managers.

Where else is so much time and talent put forth to achieve so little or, in fact, what is a net reduced outcome?

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
John Bogle: Arithmetic Quants vs Algorithmic Quants
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Through December 31, 2015.
** Think of it this way: it's essentially a choice between a small chance of picking the manager who produces long-term outperformance versus near certainty of being at or near the top ~10% or 20% in terms of long-term market performance. Also, there's still some (usually rather modest) fees to consider in an index fund that might produce a lesser outcome.
*** As always, I have no view on what near-term market prices might be. I'll leave that sort of thing to those who attempt to profit betting on price action. The focus here is definitely not on speculation; it is always on investment -- judging what something is intrinsically worth, looking for reasonable (if not considerable) mispricings, then benefiting, in general, mostly from what's produced over the long run. Valuations right now do seem to be more on the high side than not for many stocks. Or, well, let's just say it seems wise to, considering where valuations are at the present time, use conservative assumptions and lower future return expectations. Of course, higher multiples in the near-term can naturally occur. Those higher multiples may even theoretically make those with a shorter horizon (who sell) better off -- or, at a minimum, will make some participants feel better off -- but, in fact, a meaningful drop in market prices would logically make life easier for the long-term investor. Those with a substantial investing time horizon who are hoping for market prices to continue higher near-term (or even intermediate-term) should keep this in mind. It is lower market prices that increase the possibility of making incremental purchases -- whether done directly by the shareholder or via buybacks using the company's excess cash -- at a nice discount to intrinsic value. The potential long-term compounded effects for continuing owners (i.e. not traders) need not be small. Buying shares at increasingly large discounts to conservatively estimated value over time should, all else equal, reduce risks/improve returns.
(Notice the sometimes overlooked inverse relationship here. Risk and reward is at times positively correlated, but some incorrectly assume they're always positively correlated. Well, the correlation is not always positive and is, as far as I'm concerned, too often a rather underutilized consideration.)
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