"Fees never sleep." - Warren Buffett's bet

For most people, I advocate investing in low-cost "passive" investments. 

I'm not alone. Warren Buffett is probably a bigger advocate than me.

In Berkshire Hathaway's 2016 annual report, Buffett talks about index-based funds in detail. 

I quote from Buffett extensively below, but you should really read the report yourself

All emphasis is added.

Financial advice from Warren Buffett

Warren Buffett gives some clear financial advice:

"Over the years, I’ve often been asked for investment advice.... My regular recommendation has been a low-cost S&P 500 index fund."

Buffett's bet

Buffett put his money where his mouth is and made a $500,000 bet that over an extended time period, a low-cost investment strategy would get better after-tax returns than a sample of hedge funds.

He provides background to his bet:

"In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund."

He quotes some of the text from his bet:

"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. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds."

The nature of the specific bet was as follows:

"I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?

"What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides [of Protégé Partners] – stepped up to my challenge."

"For Protégé Partners’ side of our ten-year bet, Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. The five he selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager."

The results so far?

Buffett is a long way ahead:

"the five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000 [with a compounded annual increase to date of 7.1%]."

"Fees never sleep"

Buffett is quite explicit about fees:

"I’m certain that in almost all cases the managers at both levels were honest and intelligent people. But the results for their investors were dismal – really dismal. And, alas, the huge fixed fees charged by all of the funds and funds-of-funds involved – fees that were totally unwarranted by performance – were such that their managers were showered with compensation over the nine years that have passed. As Gordon Gekko might have put it: “Fees never sleep.”

"I estimate that over the nine-year period roughly 60% – gulp! – of all gains achieved by the five funds-of-funds were diverted to the two levels of managers. That was their misbegotten reward for accomplishing something far short of what their many hundreds of limited partners could have effortlessly – and with virtually no cost – achieved on their own."

He's quite explicit on this point:

"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 low-cost index funds."

Will this type of underperformance continue?

In Buffett's view, yes.

"In my opinion, the disappointing results for hedge-fund investors that this bet exposed are almost certain to recur in the future."

He adds:

"Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice. Those advisors who cleverly play to this expectation will get very rich."

Some people can beat the market, even after fees. Picking them is the hard part.

Buffett explains that "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."

Why don't wealthy people and institutions invest more in low-fee investments?

"I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed [my advice to invest in a low-cost S&P 500 index fund] when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.

"That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.

"The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive.

"In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is - on an expectancy basis – clearly the best choice."

How does this influence the advice I provide through Fairhaven Wealth?

One of the more important parts of my job is to de-fee clients. As I've discussed elsewhere, fees are important and I can save some clients thousands of dollars in fees per year.

I am not affiliated with any financial product issuers. I am an adviser, not a product salesperson.

I believe that investing in low-fee investment funds that, to the largest extent possible, track appropriate indexes, is an excellent investment approach.

Does this make a financial adviser redundant? Of course not. It's still essential to ensure that you are investing an appropriate amount of your wealth in the appropriate types of low-fee funds.  

Much of the asset allocation puzzle can be provided by a roboadviser. But as I've mentioned before, roboadvice doesn't capture the real value a financial adviser can provide:

  • The real value  a good financial adviser provides doesn't relate to the investments they recommend. The real value is how the recommendations relate to the client.
  • The real value is getting to know a client, and building a strategy that is tailored to their unique circumstances, needs, and objectives, which change over time.
  • The real value is helping clients to get clarity about their goals and priorities. This can involve helping to get couples onto the same page - as much as possible.
  • The real value is helping clients to identify the uncertainties in their lives and develop a strategy for managing risks and gaining exposure to potential upside. 
  • The real value is providing motivation and accountability as clients commit to a process and achieve long-term outcomes, which in many cases is simple but not easy

Sonnie Bailey

Sonnie is the founder and principal of Fairhaven Wealth.

Before founding Fairhaven Wealth, Sonnie worked in the legal and financial services industries for over a decade.

Sonnie first became involved with financial advice as a specialist financial services lawyer. For many years, he was an “adviser of advisers”, reviewing thousands of advice files prepared by hundreds of financial advisers, and providing feedback in relation to the quality and appropriateness of advice; industry best practice; risk management; and regulatory compliance. He has published work in industry publications and spoken at various financial advice conferences.

Sonnie has also worked with banks, investment management firms, insurers, and derivatives providers.

Sonnie has worked as a private client lawyer, focusing on succession, estate planning and trusts. He ran his own legal firm in Australia before relocating to New Zealand. He has also acted in independent trustee and company director positions.

Sonnie is passionate about helping people achieve their goals and manage the risks to which they are exposed.

He has written extensively on his blog, New Zealand Wealth and Risk, which can be found at www.wealthandrisk.nz.

Sonnie is married to his wonderful wife Chrissy, and has two young children, Ben and Anna.