I am not sure what I’d have to be smoking to make a public bet against Warren Buffett in the field of investing. But I am sure a libel laywer would have a view.

So let’s just say Ted Seides was overconfident when he took the other side of a wager against Buffett back in 2007.

The bet? That no investment professional could pick five hedge funds that would beat a cheap Vanguard S&P 500 index tracker fund over a 10-year period.

Warren Buffett has dedicated his long life to becoming the world’s richest man1 through investing. The proof is in the pudding. He has very little to gain from winning this bet – even today his firm is a quasi-active investment vehicle, and he promotes index funds for fun not profit – whereas the downside is a lot of egg on his face. You’ve got to think he was confident.

Cue warning lights.

I mean, making an investment bet against some hypothetically nervy, sleep-deprived, drug-addled Buffett might be conceivable.

But Warren Buffett confidently writing to his faithful shareholders in his annual report that nobody would win such a bet?

Back away slowly, keeping a tight hold of your wallet.

Sweaty Bet-ty

Here are some things where I’d back myself in a bet against Buffett:

• Who can eat the most vegetables from the salad counter.

• Who can talk the longest about investing without mentioning American exceptionalism, Benjamin Graham, Coca-Cola, being greedy when others are fearful, or how a farm will be productive for 30 years regardless of the going rate for farms that week.

• A 100m sprint (no golf buggies or other vehicles allowed).

• First to find your seat on a commercial flight.

• FIFA 2017 on the PlayStation 4.

Here are some things where I wouldn’t bet against Buffett:

• No-limits Texas Hold ’em poker.

• Who can eat the most hamburger dinners in a row before cracking and ordering sushi.

• Investing.

Buffett is a stock market genius. Trackers are cheap and their returns trounce most active funds over 10-year periods. Hedge funds are insanely expensive, and even their best managers face a mighty struggle in overcoming the hurdle imposed by the high fees they charge.

Talk about a loaded deck.

Seriously, it’s one thing to get rich selling active management magic that costs your clients 2-and-20.

It’s another thing to actually believe in it.

Fee high foe fun

On a personal level, Buffett says he likes his opponent in this wager. Seides does come across as a decent sort, and I certainly admire the fact that he – as a co-founder of investment firm Protégé Partners – put his money where his professional mouth was.

I mean, with trillions under management for their clients, and millions – if not billions – in the bank, you’d expect a scrum of hedge fund managers would have been falling over each other to put the yokel from Nebraska back in his place.

What a great advert for the hedge fund industry beating Buffett would be! Surely they all jumped at the chance?

Of course not. Hedge fund managers are not dumb.

Seides stepped up though, and you have to admire that. I always have a soft spot for the trooper who volunteers to take the pistol with two bullets from the Captain and heads out into the snow to seek a miracle while the rest of his comrades huddle safely in the bunker.

But where Seides really made life hard for himself in his suicidal bet against Buffett was that he didn’t just pick five hedge funds. He picked five funds of hedge funds.

This means Seides’ selections compounded the high fees charged by hedge funds with another layer of fees on top, from the fund of fund managers.

This is a bit like inviting termites onto your leaking rowboat. Money is soon pouring out of every (mixed) metaphorical orifice.

Lars Kroijer wrote an article for us about fund of fund fees. He estimated that for every $10 of return generated by the underlying funds, the actual investor might get to keep $3.

Staggering. Go check the maths.

Against all odds

To be fair, we must remember that back in 2007 hedge funds as an asset class hadn’t yet wracked up a diabolical decade of market-lagging returns.

They have now. When Pension Partners surveyed the scene in 2016, it found that:

…since the start of 2005, the HFRX Global Hedge Fund Index and HFRX Equity Hedge Index (two investable indices widely used as benchmarks in the industry) have posted negative returns (-1% and -6.4% respectively).

Over that same time period, the Barclays Aggregate Bond Index was up 62.1% and the S&P 500 up 97.6%.

Negative. Returns.

The odds were against Seides. But he might still have had a tiny chance of winning if he’d tried to somehow alight upon those few funds in the $4-trillion industry that delivered decent returns after fees over the past nine years.

However by opting for funds of funds, Seides reinforced that huge cost hurdle by condemning his returns to mediocrity, via five flocks of mutton dressed as lamb.

In his annual letter to shareholders, Buffett reveals the gory results with just one year to go:

Source: Berkshire Hathaway Shareholder Letter 2016

Forget beating the S&P 500 as a group. Only one fund of funds has got within shooting distance of the index, and even it trails it. The rest are woeful laggards.

It’s safe to say that Buffett’s nominated charity can already start to think about how they will spend his winnings.

Buffett writes:

Buffett also mentioned that he always recommends index funds to friends, but that only those of modest means and little business knowledge follow up on the idea. The financially successful feel short-changed, and seek better returns elsewhere.

This has been my experience, too. While I’d obviously wish my own friends better, from a societal perspective long may this vanity tax on the rich continue.

Work it out

I happened to see an interview on CNBC with a City professional on Monday morning, after Buffett’s letter had been released.

The gist of the interviewer’s question was that if investing legend Warren Buffett says people should use index funds, then why shouldn’t people use index funds?

To his credit, the Cityboy looked momentarily terrified.

(Note to Ted Seides: When you’re up against Warren Buffett on the subject of investment advice, terrified is the appropriate posture to adopt).

Perhaps remembering who buttered his bread, the sacrificial lamb eventually spluttered back to life. He agreed that trackers were okay for those without financial advice, but that “hard work” and professional expertise would always be able to find you those funds that outperformed.

This is nonsense. The correct statement is they might, but the odds are against it.

Hard work is always trotted out by active apologists, but almost everyone in finance works hard. And picking market-beating fund managers is the same zero sum game that active investing is, only the downside has extra knobs on due to even more fees.

Ted Seides’ superb CV includes Yale and Harvard, time spent working with David Swensen, and experience co-founding a multi-billion dollar investment shop. (His biography also sportingly references his aspirational bet with Buffett.)

By any measure Seides is an accomplished professional. If he can’t find five funds that will beat an S&P Index fund – with $500,000 of his own money on the line – then do you think it’s likely your local financial advisor on the High Street in an office above a kebab shop will do any better?

Buffy the vampire slayer

Warren Buffett is a rare kind of unicorn. Rather than tell you there’s a whole pasture of his type over the next green hill, he advises you to look for a workhorse instead.

Buffett readily agrees that some fund managers will beat the market. Besides himself, he believes that in his lifetime he’s identified – at that start of their careers, when it actually mattered – a whole ten!

He continues:

1. On and off. [↩]

Good reads from around the Web.

Diehard Warren Buffett fans like me probably already know that the octogenarian outperformer’s latest annual letter will be released today at 1pm UK time (8am EST in his native US).

This year even passive purists who see Buffett as a six-sigma sideshow might be curious, however. Because rumour has it that Warren will be going deeper into why he champions index funds.

Update: The 2016 annual later is here. Here’s an except:

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.

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. The probability is also very high that the person soliciting your funds will not be the exception who does well.

Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: “In investment management, the progression is from the innovators to the imitators to the swarming incompetents.”

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.

Nothing really new then, but always class to hear one of the world’s best ever active investors not spinning the line.

Lots else for Buffett fans to dig through too, of course.

[continue reading…]

According to Vanguard, passive funds are set to double their market share in Europe. Vanguard believes that over the next 10-15 years, passive’s slice of the pie will swell from 15% to more than 30%.

Yum, yum, says the indexing giant. The company already manages $4 trillion of our money but it wants more. It’s now calling for regulators to slap ‘health warnings’ about high fees onto expensive funds.

Maybe we should go whole hog, and insist on gory fag packet-style horror photos inserted into swanky fund literature? Emaciated and impoverished pensioners eating discount pot noodles in the rain, splashed by Cityboys screaming past in sports cars – that sort of thing?

Reuters recently quoted Vanguard’s chief investment officer Tim Buckley in colourful form:

“Active is dying from its own disease, it’s dying from its own greed. It’s high-cost against low-cost, and high-cost is the dinosaur.”

Ouch! Don’t ask Mr Buckley if your bum looks big in those.

Zero mercy

Tighter regulations such as MiFID II are set to further increase the cost of running funds. Ironically, this will probably also decrease competition by making it harder for new entrants to get started.

My own cursory look into the costs of setting up a little fund manager has persuaded me that to get rich running other people’s money, I’d have to be rich to begin with.

Low costs mostly come from economies of scale. So it will be left to the current incumbents – active and passive – to slug it out in a price war.

Vanguard has feet in both camps. Few realize Vanguard manages around $1 trillion in active funds. Low fee active funds, of course.

And costs matter because active investing is a zero sum game.

Well, almost a zero sum game. Probably. There are a few quirks that muddy the waters.

Previously we’ve not had to pay these too much attention. Some make your brain hurt. But as passive investing grows and eats up the investing landscape like a sci-fi blob from the 1950s, people are going back into the footnotes of the passive thesis and looking for caveats.

I’ll do so too in a future post. I’m no professor of economics, but for what it’s worth I believe these quibbles are of academic interest at most to the average investor, and don’t change the main argument for using market cap weighted index funds.

Zero tolerance

Anyway, many people even haven’t grasped the main argument yet. Let’s have a quick reminder.

Investing in itself is not a zero sum game. You and I can both make money in the stock market, without competing against each other.

As the economy expands, the total sales and profits of listed companies will grow. As owners of companies – whether through active or index funds – we’ll benefit as the market puts a higher value on our firms churning out ever heavier wheelbarrows of cash. We’ll also get dividends from the companies we own, whether via direct shareholdings or through funds.

So far, so good for everybody.

Here’s the zero sum bit. In order for £1 that’s invested in an active fund to win against the market – that is, to outperform the market – somewhere £1 of active money has to lose.1

That’s because ‘the market’ consists of only passive indexing and active funds.

And passive funds follow the market, so we can net those out.

This leaves the active funds (which includes smart beta ETFs and the like) trading amongst each other.

They profit at one another’s expense, but in aggregate they earn the market return.

And as they also charge higher fees, they must therefore do worse than trackers.

This logic was established more than quarter of a century ago by Nobel Prize-winning author Bill Sharpe. Read his paper, The Arithmetic Of Active Management, and see for yourself.

However be warned you might still feel befuddled afterwards.

I don’t blame you. It took me years to properly wrap my head around this stuff. I’m sure there are old articles on this website that aren’t completely on-point.

Active investors say the funniest things

You see passive investing is a weird concept. It feels wrong compared to our everyday experience. I’ve noticed even many financial professionals don’t really understand the theory behind it.

You might have heard journalists or fund managers say things like:

“Now is the time when stock picking funds will prosper over passive.”

Or perhaps:

“In this particular area of the market, active funds will always beat index funds.”

If you follow the zero sum logic of investing, you know such statements must be false. Maybe you’ve even rolled your eyes at their self-serving deception.

However I’m confident that in some cases those people don’t actually understand the active/passive arguments.

Here are some other wrong-headed things I’ve heard recently – in person and in the media – that I’m pretty sure weren’t meant as deliberate falsehoods:

As more people invest passively, it’ll definitely be easier for active funds to beat the market.

Active funds will do much better than passive when markets are falling because they can get out of expensive stocks.

Active funds can prey on the dumb money in index funds.

Index investing is Marxist.

The growth of passive investing has made markets less efficient and more volatile.

Index funds are poor performers, but at least you don’t pay much for their poor performance.

When you want the best brain surgery, you pay for the most expensive surgeon. Same thing applies with investing.

Passive investing is dangerous, because the dotcom crash / financial crash / whatever proved markets are not efficient.

Or: Markets need to be super-efficient for passive investing to work – and they’re not.

A hard-working fund manager can always beat the market.

You should invest in index funds because no active managers can beat the market.

The advanced version: You should invest in index funds because no active managers can beat the market over the long-term.

I haven’t got time to watch CNBC for 10 hours a day, so I just invest passively. It’s better than nothing.

Most of these dubious statements stem from not understanding the zero sum argument or not thinking about what it means to say markets are efficient. People also forget the huge role of luck.

But rather than debate each point myself, I’m going to direct you to a podcast on Bloomberg. (Unfortunately I can’t embed it here.)

Poker, passive investing, and a podcast

The latest episode of Bloomberg’s Odd Lots podcast – How Poker Explains The Battle Of Active And Passive Investing – centers on a paper by Michael Mauboussin, a bigwig at Credit Suisse who has long been unpicking the role of talent and luck in investing. (See his book The Success Equation).

The hosts of Odd Lots are smart, and I listen to their show most weeks.

However to illustrate my point, at least one of them doesn’t seem to understand the zero sum aspect of active investing at the start of the interview – and I’m not sure about the end, either.

But Mauboussin is patient and convincing, and well worth listening to. He’s interested in the game of active investing as well as the remorseless logic of passive. (A kindred spirit!)

Mauboussin also briefly mentions a couple of those edge cases that people sometimes bring up to contest the zero sum thesis.

As I say these – and the others he doesn’t mention – don’t change the best practical approach for everyday investors, as far as I can see. Certainly not right now, in 2017.

They will also not support a multi-trillion dollar active management industry.

After all, even if there are loopholes in the theory, the woeful market-lagging performance of most active funds in practice means such caveats are barely relevant in the real world:

Source: Vanguard/CityWire

Pretty compelling. Still, the arguments raised against the pure ‘zero sum’ mathematics do stretch your brain a bit. I’ll take the pain in a future post.

For now, get up to speed with the Bloomberg podcast. It’s a good listen.

1. Those caveats notwithstanding. [↩]