“Fees never sleep.” – Warren Buffett’s bet

(The following article is an edited repost from the New Zealand Wealth and Risk blog.) 

I’m an Authorised Financial Adviser. For most of my clients, I advocate investing in low-cost, index-based 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.”

(I wouldn’t necessarily agree with this for NZ investors, but I agree with the key point: a diversified, low-cost index-based fund is generally a good way to go.)

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.”

Trust me. Read the report yourself. It’s worth it.

(Sonnie Bailey is the author of this article and is an Authorised Financial Adviser (AFA). A disclosure statement is available free on demand: click here.)

Accelerating your path to financial independence and retiring earlier

(This is an edited repost from the New Zealand Wealth and Risk blog, originally published on 30 May 2017.) 

Life is full of seasons. There are times in life when it’s harder to build wealth, such as when you’re a student, or you have a new-born child. And there are times in life when it’s easier, such as when you’re a working empty-nester with no mortgage and serious savings.

There are a number of life events that can put you in a position to turbo charge your path to financial independence and early retirement. It’s valuable to be aware of these situations and taking advantage of these opportunities when they arise. If you’re not mindful, you might find that your excess cash gets eaten up in lifestyle expenses that, while nice, may not help you with your ultimate goal of becoming financially independent and retiring early.

For example:

When you couple up for the first time. When two people move in together, they often find that many of their expenses reduce. You often find that something that you would’ve had to buy on your own, is now effectively half the price because you’re sharing the item and its cost. It’s valuable to use this as an opportunity to increase your savings rate.

When you pay off your student loan. If you have a New Zealand student loan and you’re working in New Zealand, you effectively have a 10% additional tax on your income in the form of student loan repayments. Once the loan is repaid, you essentially get a 10% pay increase. If you were able to live without this 10% before, it’s a good idea to “pay yourself first” and let it bump up your saving rate.

When you pay off your mortgage. Paying off the mortgage is a huge financial milestone. Once the mortgage is out of the way, you’ll have a lot of extra cash flow to put towards building up wealth. (The sooner you can pay off the mortgage, the better your long-term situation is likely to be. Consider the difference between repaying a mortgage at the age of, say, 40 compared to the age of 60. That’s an extra 20 years of extra cash flow.)

When you’re able to self-insure. For any given level of cover, personal insurance premiums will generally increase over time. (The biggest risk factor for most health issues is age…) Ideally, however, your insurance needs should reduce over time as you become better positioned to self-insure. The sooner you can get into the virtuous cycle of having enough wealth to be able to self-insure in relation to most events, the less you’ll need insurance, and the more you can put the money that would have gone towards premiums into building more wealth.

Whenever you get a decent raise. If you’re used to living on a certain level of income, a raise is a bonus – you have money that you previously didn’t need. Consider pre-committing to saving a portion of any future raises, which over time, will result in the percentage of your income that you save continuing to increase.

Don’t get me wrong – when you have an event that frees up cash flow, it’s great to increase your spending and the quality of your life. But as with any spending decision you make, it’s important to make decisions that align with your long-term goals and values. If you’re reading this blog, it’s likely you’ll want to take advantage of these milestones to help you become financially independent sooner and retire earlier.