Bogle & Buffett on Frictional Costs

John Bogle had the following to say in a speech earlier this year:

"Hedge funds (so-called; actually concentrated investment accounts which offer a wide variety of strategies) manage about $2.8 trillion of assets, at a cost equal to at least 3% of assets per year (300 basis points, an informed guess), generating some $84 billion in annual fees."

Vanguard manages roughly $3 trillion with roughly two thirds being index funds. Similar size but naturally much lower costs:

"The costs of supervising these index portfolios come to about $400 million annually, or 0.02% per year (two basis points)—less than 1% of the hedge fund rate. Administering the index funds and handling the accounts of some 15 million index shareholders costs another $1.2 billion, adding 0.06% (six basis points) to bring the aggregate expense ratio to eight basis points."

The ~ 300 basis point "informed guess" is primarily driven by the 2 and 20 compensation structure that is common to hedge funds. The above comments are not unlike those made by Warren Buffett -- in reference to his bet that a low-cost S&P 500 index fund would outperform a basket of hedge funds chosen by experts -- at the Berkshire Hathaway (BRKa) shareholder meeting earlier this year:

"The result is that after eight years and several hundred hedge fund managers being involved, the totally unmanaged fund by Vanguard with very minimal costs is now 40-something [percentage] points ahead of the group of hedge funds. It may sound like a terrible result for the hedge funds, but it's not a terrible result for the hedge fund managers."

Buffett also pointed out...

"We have two [investment] managers at Berkshire. They each manage $9 billion for us. They both ran hedge funds before. If they had a 2/20 arrangement with Berkshire, which is not uncommon in the hedge fund world, they would be getting $180 million annually each merely for breathing."

And then added:

"It's a compensation scheme that is unbelievable to me and that's one reason I made this bet."

So it comes down to this big difference in frictional costs to explain the results (so far) of Buffett's bet.

Investors in these high-cost funds are betting that, over many years, a capable manager can reliably outrun such a frictional cost headwind and that somehow those investors will be able to correctly pick beforehand who that manager is going to be. As Charlie Munger said at the same 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."

The likelihood that a manager will do well ends up much higher than the likelihood those who actually put their capital at risk will do well.

It seems rather obvious that the system would be vastly improved if the opposite were true.

Tortured logic is required to explain why those who are putting their capital at risk shouldn't first be compensated sufficiently before vast sums are drained from their balance sheet.

Adam

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

Related posts:
Buffett on Active Investing
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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
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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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Hedge Funds: Balancing Risk & Reward?

This recent article by Brett Arends points out hedge funds have not performed all that well this year.

The same goes for recent years. Arends writes those "who put 20% of their money in a federally insured bank savings account, and the other 80% in a random collection of stocks from around the world, picked by monkeys," outperformed in a meaningful way hedge funds in 2012, 2013, 2014, and so far in 2015.

Well, at least to me, that seems a rather too short time frame to judge relative performance.

In this article, Morgan Housel looked at a somewhat longer period of time. He points out, from 2002-2013, hedge funds underperformed a simple mix of 60% in stocks and 40% in bonds.*

The 60/40 mix had slightly higher returns along with slightly lower volatility.**

Some hedge funds argue that their goal isn't to match or beat the S&P 500, it's to balance potential rewards with downside risk and limit volatility or something similar. So, with this in mind, both Arends and Housel chose to compare hedge fund returns to a mix that similarly attempts to balance rewards with downside risk.

I'd add that some make the assumption that risk and reward need always be positively correlated.

Well, that's just not necessarily the case.

Now, consider that the typical fees of a hedge fund will be something like two percent of assets under management plus twenty percent of the profits generated (if any).

The two percent is generally paid by investors whether there's a profit or loss.

Arends points out that this means...

"Do the math. If the average investment portfolio earns 6% a year, your hedge fund manager has to earn 9.5% before fees before you even break even. In other words, the manager has to beat the market by about 60%. Per year. Good luck with that."

It may not be impossible to outperform by that much, but consider how many experts underperform over the longer run with, in general, a much lower frictional drag from fees. Also, consider how these fees impact the risk-reward for investors. In other words, the act of reducing fees would, in itself, take out some of the downside risk which is what the hedge funds often contend is a prime objective.

And the above hedge fund results just might be an optimistic take. It turns out that the "hedge-fund indexes flatter the industry's performance, because they are weighted heavily towards the funds that survive and report data."

So how has hedge fund performance affected investor behavior?

Is there any evidence investors are moving out of hedge funds?

Not at all.

From an article in the Wall Street Journal:

"Large corporate pension funds have quadrupled the share of their portfolios invested in hedge funds over the past five years..."

More generally, hedge fund assets under management is now, depending on the source, something like like $ 2.5 trillion or maybe even $ 3.0 trillion in assets. Big numbers. That compares to just $ 38 billion in 1990. So hedge funds have been gathering assets in a substantial way over the past two and a half decades (and in more recent years). At their current size, these funds will collect some serious fees from their investors, including those pension funds, with just mediocre performance.
(The management fees alone would be $ 50-60 billion even if no profits are generated.)

I'm not necessarily surprised by this sort of thing. Better to simply recognize why the behavior exists then do whatever can be done to avoid it.

This paper looks specifically at hedge fund investor performance from 1980-2008:

"...we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008.The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought."

This inevitably now has a big impact on institutional investors (pensions, foundations, educational institutions). Why? Apparently, at least 60% of the money invested in hedge funds these days comes from institutional investors.

Adam

Related posts:
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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* Vanguard Balanced Index Fund (60/40). The fund, like many from Vanguard, is rather low cost relative to peers.
** Volatility is not the definition of risk though some choose to treat it that way.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Index Funds vs Actively Managed Funds

Some recent research by S&P Dow Jones Indices found that, among other things, the vast majority of U.S. actively managed equity funds did not beat the relevant benchmark over ten years.

Here's a quick summary of U.S. equity fund performance over a ten year period.*

- All Domestic Equity Funds: 76.54% underperformed

- All Large-Cap Funds: 82.07% underperformed

- All Mid-Cap Funds: 89.71% underperformed

- All Small-Cap Funds: 87.75% underperformed

From the report:

"It is commonly believed that active management works best in inefficient environments, such as small-cap or emerging markets. This argument is disputed by the findings of this SPIVA Scorecard. The majority of small-cap active managers have been consistently underperforming the benchmark over the full 10-year period..."

The results, with one exception, were similar for the 14 other U.S. equity fund categories included in the report.**

According to the report, "the majority of the active managers" that invest in international stocks also performed worse than their benchmarks over the same time frame.***

This should hardly be a surprising result. John "Jack" Bogle has been trying to educate others on the wisdom of low cost index funds over actively managed funds for decades.

Here's how Mr. Bogle once explained it:

"The percentage of managers outperformed by the broad market index is, well, time-dependent. On a given day, it's likely about 55%; over a year maybe 60-65%, over a decade perhaps 75-80%, and over 50 years...well, there's no data (yet!) on that!

But the probability statistics suggest that over a 50-year period, some 98% of managers will lose to the market index."

The S&P Dow Jones Indices research does "account for the entire opportunity set—not just the survivors—thereby eliminating survivorship bias." Any comparison that doesn't account for the funds that are liquidated or combined with other funds during a particular period isn't going to paint a realistic picture.

The research shows result for shorter time frames but, at least to me, ten years is barely a long enough time horizon to make meaningful judgments. It's performance over decades that matters all risks considered.

It may not be impossible to figure out which fund will outperform going forward over the longer haul, but at least investors should carefully consider just how difficult it might be.

Of course, it's possible that active managers are will do much better going forward but, if nothing else, some skepticism seems warranted.

Think of it this way:

Where else does a simple cheap product exist that offers the non-expert a chance to keep up with the experts -- or, if this research is any indication, possibly outperform the vast majority of the experts -- over the longer haul?

The tough part for many is avoiding the temptation to be more active than they probably should be and end up making inopportune portfolio moves.

Some investors tend to underestimate how excessive confidence and other factors can adversely impact results.

Some relevant Bogle advice:

1) "...in investing, realize that you get what you don't pay for. Whatever future returns the markets are generous enough to deliver, few investors will succeed in capturing 100% of those returns, simply because of the high costs of investing—all those commissions, management fees, investment expenses, yes, even taxes—so pare them to the bone."

2) "Don't do something, just stand there. Own American business...a broadly diversified portfolio of lots of companies and industries. Buy such a portfolio, never sell, and hold it forever."

3) "Invest for the long term—decades, even a lifetime—and start as soon as you can. No one knows what stocks will do tomorrow, or even what they'll do over the next few decades, but over the long pull, the dividends and earnings growth of American business will be reflected in rising stock prices."

He also says to avoid "stupid mistakes" including things like -- though not limited to -- making impulse investments, buying based upon tips, and letting emotions rule over reason.

Jack Bogle's market advice: 'Don't do something, just stand there!'

Ultimately, the "humble arithmetic" is unavoidable.

Adam

Related posts:
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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* See page 4. Source: S&P Dow Jones Indices LLC, CRSP. Data as of Dec. 31, 2014. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results.
** Large-Cap Value Funds: 58.76% of the funds underperformed their benchmark index over ten years. This may be a relatively better performance versus the other categories, but most funds in this group still could not outperform their benchmark.
*** Results on page 10.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

John Bogle on Investor Returns

Some things of note from a recent Vanguard study that's cited here by John Bogle:

- 90% of investors in traditional index funds are long-term holders, while only 80% of investors in ETFs are long-term holders.
- Investor returns in traditional index funds lag the returns of the funds by 150 basis points.
- Investor returns in ETFs lag the returns of the funds by 250 basis points.

Active Managers Losing Ground Can Thank John Bogle

So, in both cases, investor results are subpar compared to the funds and those who are less long-term oriented end up lagging by a greater amount. It's investor behavior that's mostly behind the reduced returns. The ongoing attempts to be in or out at the right time based upon market conditions ends up, too often, just subtracting from results. In other words, some variation of buying when the world seems less uncertain (when stocks are more likely to not be cheap or even expensive) and selling when the world seems more uncertain (when stocks are usually most attractive in terms of risk and reward). That's a tough way to get satisfactory results when this pattern of behavior is repeated over a longer time horizon. Lots of additional effort; less than satisfactory returns. A more consistent approach along with ignoring most of the noise would have yielded better results. Essentially, it's Newton's Fourth Law. The world inevitably swings from what appear to be favorable investing environments to those that appear much less so.

Market participants respond to these changing environments to an extent in a calculated way (efficient market adherents certainly tend to think so), but also to a significant extent based upon psychological and other factors.*

Cognitive biases and emotions can dictate price action in the shorter run.

Being among the not so large group that, over the long haul, can produce results that exceed a broad-based market index is easier said. It seems improbable that recognition of this reality will change behavior all that much. Instead, plenty of active market participants will continue trying to be in or out of a particular fund (or stock) at or near just the right time -- in an attempt to outperform -- despite the near futility of acting in such a way.**

Reduced activity can be a big advantage with a sensible portfolio -- built with specific limits and circumstances in mind -- that's purchased steadily over time.

Fear and greed -- or, more generally, the fact that participants can be less than than cold and rational especially in large groups -- isn't going to stop having a big influence on investor behavior anytime soon.

Assets get mispriced -- anywhere from big premiums to big discounts -- but this only becomes obvious to the vast majority of participants after the fact.

It's not that no one can time things correctly. No doubt there are exceptions who can do just that sort of thing. It's that, apparently, too many are overconfident that they'll be able to do so.
(At least based on the fact that most actively managed equity funds can't match the performance of an index fund.)

Bogle describes some of the more specialized ETFs -- those that are niche products and sometimes use leverage -- as the "fruit and nutcake fringe" and says that they are "poision for investors."

He also mentions the following:

- The SPDR turns over 7,000% each year. For perspective, he considers 3% to be stretching the limits of what makes sense.

- When it comes to the experts who think they can advise someone to be in a particular sector at the right time:

"Advisers or whoever saying you should get out of healthcare and into technology or into financials. That's a way to manage money that doesn't work. Who knows what will do best? I don't even know anybody who knows anybody who does." - John Bogle

What matters naturally is what the companies themselves produce in terms of excess cash per share -- the main driver of intrinsic value -- over time. It's the compounded effect of increased earnings that are at least mostly put to reasonably good use (incl. dividends and buybacks).

Multiples will expand and contract, but a good investment result shouldn't depend on a getting a great price when it comes time to sell.***

Of course, those who get a chance to buy something unusually cheap, hang in there for a very long time, can gain a big advantage if they're able to sell years down the road at a more normalized (or better yet, premium) market valuation.

Consider that possibility a bonus. That's more good fortune than most should count on.

In the end the whole process requires discipline -- incl. an awareness of limitations and acting accordingly within those limitations -- more so than brilliance.

Adam

Related posts:
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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* Some efficient market true believers might argue otherwise. Another factor to consider when it comes to what sets near-term prices isn't business fundamentals or psychology but the possibility that a build up of excess leverage in the system (margin) leads to forced selling when the next surprise arrives. Intrinsic values may be mostly unaffected but near-term price action certainly will be.
** Attempts at timing the market or a particular stock has usually been a recipe for poor results caused by unnecessary and costly mistakes. Now, this is very different than buying or selling based upon how price compares to intrinsic value with the emphasis being on margin of safety and long-term effects. For those comfortable valuing stocks (i.e. partial ownership of a business) this can make a whole lot of sense. Otherwise, for those not comfortable valuing stocks, that's where index funds bought periodically come into play. For participants overall the returns can be no more than market returns minus frictional costs. Of course, it's certainly possible that the most active participants will perform better in the future than the past suggests, but some skepticism seems warranted.
*** Whether a basket of stocks via a fund or an individual stock, the changes to per share intrinsic value over the longer haul compared to the price paid upfront should represent a good result even market prices aren't generally selling at a high multiple of then current normalized earnings.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Buffett's Hedge Fund Bet

Warren Buffett made a bet quite a while back with Protege Partners, LLC. He bet that, over ten years, an S&P 500 index fund* would outperform a basket of hedge funds chosen by Protege.

The bet started in 2008 and goes through 2017.

Well, Buffett is well ahead seven years into the bet.

More specifically,it turns out that, seven years in to a ten year bet, so far Buffett is up 63.5% while Protege Partners is up an estimated 19.6 % (this is an estimate because some of the funds returns are yet to be finalized).

Here's an excerpt of Buffett's argument: "A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors."

And an excerpt of Protege's argument: "There is a wide gap between the returns of the best hedge funds and the average ones. This differential affords sophisticated institutional investors, among them funds of funds, an opportunity to pick strategies and managers that these investors think will outperform the averages."

So Buffett is betting on a more passive approach while Protege is advocating a more active approach. A charity of the winner's choosing will get $ 1 million once the bet has been complete. It turns out that Buffett and Protege initially put $ 320,000 each into a zero-coupon bond with the idea that its value would be roughly $ 1 million when it came time to donate the money. Well, both sides agreed -- after the zero-coupon bond did rather better than expected due to the substantial drop in interest rates -- to sell the zero-coupon bond in 2012 and put the money into Berkshire Hathaway's (BRKb) Class B common stock.
(Buffett has apparently promised to pay the full amount if the stock ends up being worth less than $ 1 million at the end of the bet.)

In fact, Berkshire's stock has rallied quite a bit since they made that switch. The value currently sits at $ 1.68 million. So the initial investment by both Buffett and Protege seems rather likely to be worth much more than $ 1 million once this bet is settled.

Buffett wrote the following in the 2013 Berkshire letter:

"...the 'know-nothing' investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.

If 'investors' frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties."

Consistent with this thinking, he has instructed a more passive investment approach for his wife's future benefit:

"My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.)"

Buffett has previously made a similar point. He thinks that many investors would end up better off if they simply bought index funds on a periodic basis. John Bogle and others seem to think along the same lines.

The emphasis being on increases to intrinsic value and long-term effects instead of cleverly timing price movements. It's generally foolish to try and time the market (or, for that matter, an individual stock) though obviously that doesn't stop many from trying to do so.

Attempts at clever timing tend to subtract from results.

Act accordingly.

Stocks, in general, seem not at all cheap these days. That doesn't make it time to sell. To me, it means lowering expectations and learning how to deal with the inevitable but unpredictable price moves. Substantial price moves may be inevitable, but it's nearly impossible to know when and by how much. Stocks (and funds) will drop dramatically from time to time. What's expensive goes on to become even more expensive. So assume that predicting near-term price moves is nearly futile.

Better to expend energy elsewhere.

Those who can't handle the fluctuations -- sometimes driven more by psychology than fundamentals -- likely won't do all that well in stocks or funds. Too often, they end up buying and selling at inopportune times.

So trying to time price action is not a solution; it likely creates more problems than it solves. Now, for those inclined/able to judge price versus value and in a position to act decisively, the next big decline should be viewed as an opportunity. Pay sensible prices and simply expect, ignore, or even benefit from the price action. The price paid is in an investor's control; most everything else is not. If a good business is bought cheap and intrinsic value increases at a satisfactory rate, those fluctuations should over time increasingly look meaningless once the weighing machine asserts its influence. What about those who don't feel comfortable judging business economics and whether a particular enterprise has real durable advantages? Well, as Buffett has pointed out, they can do just fine as long as they recognize their own limits.

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."

Excessive buying and selling, even if thoughtful and well-intentioned, will too often just create unnecessary frictional costs (taxes, commissions, etc.) with little benefit otherwise.** The same goes for the fees that are typically charged by hedge funds. Those costs are incurred by investors -- transferring wealth in the process -- whether there's lots of trading activity by the fund or not.

Of course, it's not as if there aren't a large number of investors who are capable of doing very well owning individual stocks. Many, in fact, do very well.

Buffett once wrote that those who are "able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages," can do just fine.

It's just that too many also have an unwarranted confidence in their own capabilities especially once all the frictional costs are taken into account. Lots of incremental effort with no incremental benefit (or, in enough cases to at least be of interest, returns that are made worse by all the activity).

As a result, the vast proportion of market participants -- and it's not just the amateurs -- can't match the performance of a minimal effort required low-cost index fund that's bought periodically, almost never traded, and held for the long-term.

The emphasis is on how the business (or businesses) increase intrinsically in value instead of trading the price movements or, as Buffett calls it, attempting "to dance in and out".

Long-term investors in individual common stocks need not have some special talent for trading; they need to understand how price compares to value; they need to have the patience to wait until the price-value comparison is hugely in their favor and stick to owning what they truly understand.

Sounds simple enough.

In many ways it actually is.

It's just not all that easy.

That's because the simplicity is deceptive.

Lots of discipline and hard work is still very much required.

Important qualitative and quantitative elements must be carefully considered.

Psychological factors that can impact results must be understood then managed or, at the very least, the damage that various biases can do needs to be contained.

They aren't just someone else's problem.

Also, temperament come into play.

Common stocks can make sense for those who feel comfortable judging and valuing individual businesses; index funds make more sense for those who do not.

Some will overestimate their own ability to pick stocks consistently well; they'll end up doing a bunch of work that adds nothing to returns and might even subtract. With individual stocks, it's far more likely that big and costly mistakes -- including substantial permanent capital loss -- will be made.

With index funds, psychological biases and temperamental factors still matter; discipline is still required.

Otherwise, index funds should require a whole lot less work and far fewer difficult judgments compared to stocks.

Adam

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

Related posts:
The Curse of Liquidity
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
Buffett on "Asset Gathering" vs "Asset Managing"
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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
Recent Study on Investor Returns
When Genius Failed...Again
Best Performing Mutual Funds - 20 Years

* Vanguard 500 Index Fund Admiral Shares (VFIAX).
** Excessive activity can also lead to mistakes. Each move is an opportunity to improve results; it's also an opportunity to make things worse. It's easy to put too much emphasis on the former while giving too little consideration for the latter.
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