An Investment Bet That Is Hard To Forget

Why billionaire active investor Warren Buffett is also an avid supporter of index funds.

Investing should never be about making bets, even calculated bets.

But there are exceptions to the rule, especially when the person betting is one of the world’s most successful, and famous, investors.

American businessman and investor Warren Buffett, now aged 93 and with an estimated net worth of US$132 billion, is chairman of the Omaha-based multinational conglomerate Berkshire Hathaway.

His investment successes over many decades have largely been tied to identifying undervalued companies and taking large, long-term shareholding positions in them.

“I can’t remember a period since March 11, 1942 – the date of my first stock purchase – that I have not had a majority of my net worth in equities, U.S.-based equities,” the multibillionaire told Berkshire Hathaway shareholders at the company’s 2023 annual meeting.

“And so far, so good. The Dow Jones Industrial Average fell below 100 on that fateful day in 1942 when I ‘pulled the trigger’. I was down about $5 by the time school was out. Soon, things turned around and now that index hovers around 38,000. America has been a terrific country for investors. All they have needed to do is sit quietly, listening to no one.”

Betting on index funds

Buffett has built his career and fortune as an active investor, but over the years he has repeatedly extolled the benefits of investing in index-tracking funds with a broad spread of shareholdings.

“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals,” he told Berkshire investors in 1993.

Almost a decade later, in 2002, he reiterated to Berkshire investors: “The people who buy those index funds, on average, will get better results than the people that buy funds that have higher costs attached to them, because it is just a matter of math.”

And then, in 2007, Buffett proceeded to really prove his point by making a “simple” US$1 million wager. He challenged a United States-based hedge fund manager that he could outperform him, over a 10-year period, by investing in a Vanguard fund tracking the well-known S&P 500 index.

As a counter strategy, the hedge fund manager picked five funds-of-funds (funds that invest in portfolios of different investment funds) that he expected would outperform the U.S. share market.

Buffett shared the final results to Berkshire shareholders in 2017, describing them as “an eye-opener”.

“The five funds-of-funds got off to a fast start, each beating the index fund in 2008,” Buffett noted. “Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund.”

The final outcome, he said, reflected the large amount of fees payable to the investment managers of the five respective funds-of-funds and the 200-plus managers of the underlying funds they had invested in. This compared with the very low management fees that are payable on investments in index funds.

Buffett pointed out that while the U.S. share market had recorded strong growth over the 10-year stretch, earning many active investment managers large amounts of fees, their investors had “experienced a lost decade” because of these fees.

Investors are getting the message

Investors around the world have been gravitating towards low-cost broad-based index funds for some time, and at the end of 2023 a major milestone was passed.

According to data from Morningstar, the total assets under management in exchange traded funds (ETFs) and notes along with passively managed mutual funds reached a combined US$13.29 trillion at the end of December 2023, surpassing the US$13.23 trillion held in active funds.

In Australia there are now more than A$700 billion of indexed assets under management, with the domestic ETF industry alone holding almost A$200 billion of investors’ assets as at 31 March 2024.

Data released in March by S&P Dow Jones Indices shows 76.5% of Australian equity actively managed funds struggled to keep up with the share market’s performance over 2023 – the second-highest underperformance rate on record.

The underperformance picture hasn’t really changed over time either, even going back to when Buffett made his comments to Berkshire shareholders back in 1993.

In Australia, just over the last 15 years, 85.3% of Australian equity general funds have underperformed the broader Australian share market.

“Within capitalism, some businesses will flourish for a very long time while others will prove to be sinkholes,” Buffett told his company’s shareholders last year. “It’s harder than you would think to predict which will be the winners and losers. And those who tell you they know the answer are usually either self-delusional or snake-oil salesmen.”

The next Berkshire annual meeting is scheduled for 4 May in Omaha, where once again all eyes and ears will be tuned in to what Buffett – the man colloquially known in the investing world as the “Oracle of Omaha” – has to say about his investments and investing strategies in general.

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General Advice Warning: This article contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information.

Original Article: Vanguard (2024). An investment bet that is hard to forget.

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