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Video: Warren Buffett explains why passive index funds MUST beat active investors overall

I have explained in the past that while everyone can expect to do well from investing in a broad basket of shares over time, seeking to try to do better than the market – active investing, in other words – is a zero sum game.

In that long post I wrote:

…‘Alpha’ cannot be magicked out of thin air.

The only place an active manager can go to get more or fewer shares than are held by the market is by dealing with other active investors in that market.

(Because the passive investors by definition hold the market).

And then you have to subtract those higher costs.

Those higher costs mean that in aggregate, investors in active funds see lower returns than passive investors.

Now, this doesn’t mean any individual active investor – or active fund – can’t do better than the market.

Some can beat the market, and some very few do.

What it means is that overall, as a group, they must do worse than the equivalent passive index funds.

It means ignoring marketing rubbish like “active funds come into their own and trash trackers when the market goes down because they’re able to take action to sell the expensive shares” or similar nonsense.

As a group, this is impossible. They can only buy and sell shares to other active investors. Hence one active fund can only win at another active fund’s expense. In the meantime, investors in both the winning and losing active fund are paying higher cost than index fund investors, so in sum they are losing out.

(All that said, some active funds do better than index funds in bear markets – but this is typically because they hold a slug of cash to meet client redemptions, and this cash doesn’t fall when the market does. In contrast index funds are always very near fully invested).

Warren Buffett explains the truth about active investing

I’m still pretty happy with my explanation of why active investing is a zero sum game – and it has a cool graph courtesy of Vanguard – but I will happily defer to Warren Buffett on almost anything, including this.

Because Buffett just gave a simpler and clearer explanation to some 40,000 people at the Berkshire Hathaway annual shareholder meeting.

You can watch his explanation in the video below.

Unfortunately Yahoo Finance doesn’t allow me to start the video at the specific spot, so you’ll need to manually fast-forward to the 2h 42m and 20 second mark:

After explaining how he is wildly wining his bet that a low-cost S&P index fund would beat a handpicked collection of hedge funds, Buffett quipped:

“Now that may sound like a terrible result for hedge funds, but it’s not a terrible result for the hedge fund managers. […]

There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities.”

Keep watching past the recap of his anti-hedge fund bet to the section where Buffett divides the stadium audience in half, and explains how the passive 50% must do better than the active 50%.

I literally couldn’t do better myself. (I tried!)

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{ 13 comments… add one }
  • 1 weenie May 2, 2016, 5:51 pm

    Thanks for posting the video – like you say, you couldn’t have said it better yourself!

  • 2 R Lee May 2, 2016, 10:40 pm

    I am passive to the very core – VUKE and VWRL, and a couple of mainstream Investment Trusts to make me feel I am living really dangerously – but I think you and WB are over egging the passive pudding. A zero sum game is not a game with no winners, it’s a game with as many winners as losers. So saying the market is a zero sum game is true but not interesting. The men’s final at Wimbledon is a zero-sum game. Is that an argument for either of the competitors not to try to win it, or indeed not to turn up to it, or a reason for predicting that neither finalist will in fact win it, because it stands to reason that the finalists as a group will neither win nor lose overall? The valid reason for not participating in the active investing game is that you have no particular reason to believe you are any good at it, which has nothing at all to do with its being zero sum.

  • 3 The Investor May 2, 2016, 11:27 pm

    @R Lee — We’ve been through all this before, possibly with you in the last article (I can’t recall).

    In fact, I’ve just checked and it was you! My memory, eh?

    Any readers who are interested in finding out more should see the comments to the zero sum article.

    For a person who talked about the “straw man fallacy” last time, your Wimbledon comparison is pretty much a giant haystack!

  • 4 john May 3, 2016, 11:53 am

    A point that is rarely made on this subject, but is extremely, extremely important, is that the hedge funds with statistically significant outperformance (IR >2 for 5 years) are all closed to new investment. As such these funds have very low weight in the protege basket that the s&p is up against in the buffet bet. They don’t appear at all in the hedge fund universe that is used for the hedge fund indices. That universe is made up of funds that are being pushed by brokers and are totally useless.

    None of this means you should invest in hedge funds. The closed funds are closed and the game is zero sum. Amazing funds do exist though.

  • 5 Naeclue May 3, 2016, 11:59 am

    @ R Lee, The difference is that tennis is a game of skill, successful investing is predominantly skill-less once the basics are learnt. Are you going to improve your odds of winning snakes and ladders if you keep playing, or bet on someone with a superb past record?

  • 6 R Lee May 3, 2016, 12:45 pm

    @Naeclue it would be very odd if that were true; there is no other field of human endeavour where there is basic competence, but the scale stops there. Some of us can drive ok, some of us are Lewis Hamilton. Some of us can invest quite sensibly, some are W Buffett and JM Keynes. I am not, which is why I invest mainly in index funds (with a couple of ITs whose managers I have to say do a pretty good job of beating their benchmarks), but no argument benefits from being overstated.

  • 7 JonWB May 3, 2016, 2:01 pm

    @John said: “A point that is rarely made on this subject, but is extremely, extremely important, is that the hedge funds with statistically significant outperformance (IR >2 for 5 years) are all closed to new investment.”

    Agreed. As a retail investor (of any sort), you are usually the lowest of the low in any preferential pecking order for anything to do with investment (even if a High Net Worth). If I’m from the Harvard Endowment Management Company, then not only does any fund worldwide take my call, they will likely consider opening a closed fund and certainly bump me to the top of the allocation for any new fund. They may even set up a bespoke private fund for me. Why? Because Harvard carries significant brand value for the fund. These funds care deeply about the quality, reliability and brand value of their investors capital. They are also accutely aware (like Buffet is) that outperformance is much harder the larger your assets under management become.

    If you want to invest in an active fund, the real question to ask yourself is: “Why does this fund want my capital. Why can’t they get better quality, reliability and brand value of capital elsewhere and doesn’t that tell me everything I need to know.”

    @R Lee @Naeclue There is a tennis analogy. I can probably secure an investment in a tennis player, who is say, ranked 300-400 in the world (either gender). They would gladly take my money to aid their development and we could split all future prize money / endorsements through a commercial arrangement. I have zero chance of doing this with someone ranked 25-50 in the world. However, I suspect if Harvard / Bjorn Borg / Martina Navaratilova called and asked for some form of joint venture, it would at least be seriously considered by a 25-50 player.

    There is a very small possibility that this is the same player, but separated by say 5 years. The problem is that as an individual, you have to identify which player in the 300-400 rankings becomes a 25-50 ranked player in 5 years time. Is is possibly not so different with active fund managers and track records.

  • 8 The Investor May 3, 2016, 2:17 pm

    Yada Yada Yada. Buffett’s opponent in the bet is a fund of fund manager who could pick whatever he likes from the whole universe, and he’s still lagging by 40%. The “magic club” is a point worth knowing if you’re keen on knowing a lot about hedge funds, but I’d argue it’s misleading to most readers here and statistically pretty irrelevant.

  • 9 Naeclue May 3, 2016, 3:56 pm

    Here is a Tennis anology to illustrate how tennis differs from investing.

    Pick 100 pairs of players from the top 100 seeds and have tennis fans predict the outcomes. Look at the distribution of results and you will find it skewed such that most tennis fans were very good at predicting the outcome of such an experiment. The average fan would be right more than 50% of the time.

    Now do the same thing with FTSE 100 stocks and investment managers. Randomly pick 100 pairs of stocks from the FTSE 100 and for each pair have fund managers predict which stock will deliver the best return over the following year. There is now fairly overwhelming evidence from the analysis of fund returns to suggest that the distribution of results that fund managers would achieve would match that of results had the winner of each pair been picked randomly – a normal distribution with the average fund manager being right 50% of the time. Some will be better than average, some worse, but the overall distribution would show results were indistinguishable from random chance.

    Take the thought experiment one step further* and fire all those fund managers with below average stock picking ability and run the experiment again. Again, evidence would suggest that you will then get the same result as before – a normal distribution with the average manager predicting correctly 50% of the time.

    I think the fact that active fund management is akin to playing snakes and ladders is actually very unintuitive by the way, so don’t think badly of someone who questions this. We are hard wired (and conditioned) to think that some fund managers must be better than others and we can get better than average results by paying those who appear to be better than average to invest on our behalf.

    I am not saying that there are not some outstanding managers. There is insufficient evidence to discount such a possibility, but if there are then they must be very rare otherwise they would show up as a statistically significant fat tail in the analysis of fund managers returns.

    *This will only ever be a thought experiment as I think it most unlikely that fund management groups would agree to be tested.

  • 10 john May 5, 2016, 7:07 pm

    @TI The bet was on the basket of funds held by protege. Although they can pick any fund in the “universe” that universe does not contain a single high performance fund. This is the point I was trying to make.

    I try to be clear in saying I don’t disagree with your main thesis when I comment. It would be a shame if the readership were mislead by what is said in here but factual accuracy is still important.

  • 11 The Investor May 5, 2016, 11:11 pm

    @john — Fair enough, and thanks for following up. I don’t think I covered myself in glory in this discussion to be honest, perhaps I got out of bed the wrong side that day.

    Interesting what you say about the standard hedge fund indices not including funds that are closed to new investment. I knew these indexes are somewhat debated but I wasn’t aware of that specific criteria — do you have a good source to more information on the subject beyond any random Googling I might do?

  • 12 john May 6, 2016, 4:18 pm

    Protege refuse to disclose which funds they hold (it’s their IP), but they have an internal hedge fund which is though to be in the basket.

    Hedge fund indices are made using returns that are reported to one of the index providers. Closed funds almost never report since they’re not seeking investment. Of course, some shops only report their flagship’s returns so there is self-selection bias coming back the other way too.

    The best source of info I’ve seen is the HFI award data. I guess the famous funds will report 5 year returns if there’s an award in it. Anyway the top guys have annualized >15% with much less vol than the SNP. On the other hand there’s no guarantee they’ll do it again and you can’t invest.

  • 13 John May 10, 2016, 2:14 pm

    I understand what you say about investing just in passive trackers and ‘set and forget’ it, but dont active funds such as Invesco Perpetual High Income fund perform better than passive trackers? Even with the high charges!

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