one of the questions I always get when I tell people that index investing is a good investment strategy is what about Warren Buffett the premise is that if it's possible to beat the market as Warren Buffett has for longer than I've been alive why would anyone settle for boring market returns with index funds I'm Ben Felix Chief investment officer at pwl Capital and I'm going to tell you why Warren Buffett does not prove that active management is a smart approach to investing and why you should take Buffett's advice instead of trying to emulate his results
and yes I will also address Buffett's cash pile and what it means for most [Music] investors since Warren Buffett took control of birkshire Hathaway in 1965 the stock has returned an annualized 19.8% through the end of 2023 nearly doubling the return of the S&P 500 over the same period that is incredible and over such a long period it has resulted in enormous wealth for anyone who held on to the stock over that time it's obvious why people question the validity of index investing when investors like Buffett exist while the full history back to 1965 is
beyond impressive recent history has been less favorable before I continue I want to say that Warren Buffett is a wealth of knowledge and wisdom and a pleasure to listen to and read I don't want to come off as disrespectful or dismissive of his success but birkshire Hathaway has underperformed a Vanguard us Equity index mutual fund net of fees for the 22 years ending October 202 four Buffett was asked about berkshire's underperformance at the 2020 shareholder meeting Buffett mentions that his best year managing money was in 1954 when he was managing peanuts in his words a
relatively small amount of money but it's gotten a lot harder to outperform with larger amounts of money he explained that his advice to most people is to invest in S&P 500 index funds and that while he believes that Burkshire is still a solid investment he would not bet his life on whether they will beat the S&P 500 over the next 10 years Buffett also says that while they may be a few managers out there that can beat the market it's very hard for anybody to identify them before the fact once it's obvious that they are
good managers they run into the same problem as Buffett of getting too large to continue their outperformance this is really the Crux of the problem there's a simple but important Concept in active fund management diminishing returns to scale the larger an active manager's base of assets gets the harder it gets for them to outperform the market yes Warren Buffett is brilliant and has been able to beat the market but that does not mean that he will be able to continue beating the market forever as Buffett correctly acknowledges this is the same point made in a
highly cited 2004 academic paper where the authors describe an efficient market for manager skill they suggest that investors will identify skilled managers based on their past performance and allocate to those managers up to the point that they can no longer beat the market the result is that the most skilled managers have the largest funds but their investors simply earn returns in line with the risk they are taking which they could do much cheaper with an index fund finding the rare good active managers before they become too big is beyond challenging and finding them once they
are known makes it less likely that you will reap the benefits of their skill forgetting about the issue of diminishing returns to scale for a minute the other challenge is that by the time an active manager has sufficient track record to prove their skill there's a good chance they are close to retirement Buffett is an anomaly still working at 94 years of age but acknowledging the limits of human lifespans he has brought in successors Ted and Todd Colmes the problem though is that while I have no doubt that these men are brilliant they have so
far trailed both Buffett and the market it's even hard for the best active managers to pick future winning managers before the fact it should come as no surprise then that despite his years of great results and clear business Acumen Buffett is one of the biggest Advocates of index investing this is something he has come back to repeatedly in his shareholder letters and meetings for decades in the 1996 letter to shareholders Buffett explains that most investors both institutional and individual will find that the best way to own Common Stocks is through an index fund that charges
minimal fees those following this path are sure to beat the net results after fees and expenses delivered by the great majority of investment professionals that has proven to be true again and again as far back as the data have been tracked actively managed funds that attempt to beat the market are much more likely to underperform and increasingly so at longer Horizons the other problem is that there's no evidence of persistence meaning that picking the best active Managers from let's say the last 10 years does not give you a better chance at having winning managers for
the next 10 years Buffett has so much conviction in his views on index funds that in December 2007 he entered a 10-year bet with at the time $1 million on the line that prot Partners an advisory firm well-versed in manager selection could not pick funds that would beat an S&P 500 Index Fund Protegé Partners picked five funds of funds containing in aggregate more than 200 hedge funds Buffett won the BET easily as he explains in his 2017 letter to shareholders after winning the BET Buffett wanted to make the point that investors in aggregate are not
getting their money's worth when they pay high fees for investment management and that most investors are likely better off simply investing in lowcost index funds Buffett also puts his money where his mouth is or at least he will once he passes away in his 2013 letter to shareholders he explains that his advice to invest in index funds is essentially identical to certain instructions he has laid out in his will one bequest provides that cash will be delivered to a trustee for his wife's benefit his advice to the trustee could not be more simple put 10%
of the cash in short-term government bonds and 90% in a very lowcost S&P 500 Index Fund Buffett believes the trust's long-term results from this policy will be superior to those attained by most investors whether Pension funds institutions or individuals who employ High fee active managers buff confirmed that this is still the case as recently as the 2020 shareholder event in the 2016 letter to shareholders does acknowledge that there will be some successful active managers he says there are of course some skilled individuals who are highly likely to outperform the s&p500 over long stretches in his
lifetime though he has identified early on only 10 or so professionals that he expected what accomplish this feat 10 or so in his lifetime that's something to think about Buffett concludes this section of the 2016 letter with this the bottom line when trillions of dollars are managed by wall streeters charging High fees it will usually be the managers who reap outsized profits not the clients both large and small investors should stick with lowcost index funds the message from Buffet here could not be more clear he's often held up as the example of successful active management
but he himself thinks that the vast majority of people should keep it simple and capture market returns using lowcost index funds despite Buffett's good advice I know a lot of investors do want to look for an edge the good news is that academic research may have been able to explain Buffett success using multiactor asset pricing models that means in simple terms that Buffett may have systematically held more of certain types of stocks allowing him to beat the market this is interesting because it's more repeatable than a special ability to pick stocks a 2018 paper in
the financial analyst Journal titled Buffett's Alpha sets out to explain Buffett's past performance in terms of exposure to No One return premiums a return premium is like a group of stocks with shared characteristics that have systematically higher average Returns the authors of Buffets Alpha find that accounting for exposure to the market beta size value momentum betting against beta and quality factors plus the use of some leverage largely explains Buffett's past performance in other words Buffett's success is explained by his systematic preference for cheap safe highquality stocks combined with his consistent use of Leverage to magnify
returns while surviving the inevitable large absolute and relative drawdowns this entails in fact controlling for these factors makes Buffett's alpha or his ability as a manager to produce returns in excess of the risk taken through Factor exposure statistically insignificant I know that statement is heretical to Buffet acolytes but it's true it's important to acknowledge here that explaining Buffett's performance with the benefit of hindsight does not diminish his outstanding accomplishments as an investor it took academic research more than 50 years to catch up and explain Buffet's results but the reality for an investor today is that
we do know that these factors exist that these return premiums exist they explain Buffett's performance and we can Implement them in a more Diversified and systematic way than Buffett did the authors find that a systematic Buffett style portfolio a diversified portfolio that matches berkshire's beta idiosyncratic volatility total volatility and relative active loadings performs comparably to birkshire hathway itself together this suggests that Buffett's genius is at least partly in recognizing early on implicitly or explicitly that these factors work applying leverage without ever having to fire sale and sticking to his principles this paper also touches on
how Berkshire Hathaway has changed its style over time early on when the returns were exceptionally High Buffett favored smaller firms and only became biased toward large firms later in the analysis period this suggests again that Buffett's diminishing returns could be related to capacity constraints fitting the model of diminishing returns to scale before I conclude I need to mention Berkshire Hathaway's increasingly large cash Holdings this is often referenced as a sign that investors should also be going to cash or at least that they should be concerned about potential market crash Buffett was asked about this at
the 2019 shareholder meeting an attendee asked Warren you are a big advocate of index investing and of not trying to time the market but by having Burkshire hold such a large amount of cash and T bills it seems to me you don't practice what you preach Buffett had a great answer as he always does he first acknowledges that it is a perfectly decent question and suggests that investing in index funds rather than cash may be a strategy that his successors at Berkshire should employ because on balance he would rather own an index fund than carry
treasury bills he does note that owning index funds in 2007 or 2008 might have affected berkshire's ability to make their opportunistic moves in late 2008 or 2009 but that this execution problem matters more with hundreds of billions of dollars than it does with a billion or two overall though he agrees that it's a perfectly rational observation and acknowledges looking back on a long bull market that the opportunity cost really does jump out at you Buffett goes on to to say and this is the key for most of you watching who I suspect don't have hundreds
of billions in cash let alone a couple billion that he would argue that if you were working with smaller numbers it would make a lot of sense to invest in index funds rather than holding cash while waiting for investment opportunities Warren Buffett is one of the greatest investors in history with a long track record of beating the market if you can find the next Warren Buffett you should absolutely invest with them but that's easier said than done and as the existing Warren Buffett him self will tell you he is no longer the obvious answer to
beating the market and he hasn't been for a while this illustrates one of the biggest challenges of active management and is consistent with Theory and empirical observations on diminishing returns to scale trying to find the next Warren Buffett before the fact is likely to be extremely difficult as Buffett himself has learned with the performance so far of his successors and finding them after the fact is likely too late to benefit from their skill Buffett's advice in no uncertain terms is that most investors should simply minimize their costs and invest in lowcost index funds I tend
to agree with him though I do depart from Buffett on International diversification Buffett suggests investing in S&P 500 index funds I'd add more stocks outside of the US for investors who must try to beat the market the good news is that Diversified systematic strategies that tilt toward factors with higher expected returns like safe high quality cheap stocks plus a bit of Leverage can explain the historical results of birkshire hathway implementing a systematic strategy in this fashion is more likely to be successful than reading financial statements and picking individual stocks thanks for watching I'm Ben Felix
Chief investment officer at pwl Capital if you enjoyed this video please send it to someone who can't stop talking about Warren Buffett
