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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 [1] 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 [2].

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 [3] 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 [2]!)