September – December 2023 Warren Buffett
Business & Finance
Warren Buffet made a bet 11 years ago with anyone who wanted to take him up on it that net returns on a passive investment in an S&P 500 index fund would beat returns on any other actively managed fund the person on the other side of the bet wanted to select, over a 10-year period. I think it was a $1 million bet, and both parties had to agree to donate the proceeds to a charity of his or her choice. Last year, the bet ended, and the passive strategy won out. A big portion of the reason Buffett made that bet is that fees on most actively-managed funds are 0.5% to 1.5% of Assets Under Management (AUM), and those fees really impair returns, especially when you consider their negative impact on compounding of returns over a meaningful period of time. Though we’ll talk about passive vs. active investment strategies more later on in this course, I’d like to get you thinking about it now. Comment on your thoughts about active management vs. a passive strategy of investing in an index fund with substantially lower fees (0.1% to 0.2% of AUM).I’ve included some excerpts from Buffett’s comments on his “bet”, and some of his comments on fees below, FYIFROM THE 2017 LETTER TO STOCKHOLDERS:“The Bet” is Over and Has Delivered an Unforeseen Investment Lesson Last year, at the 90% mark, I gave you a detailed report on a ten-year bet I had made on December 19, 2007. (The full discussion from last year’s annual report is reprinted on pages 24 – 26.) Now I have the final tally – and, in several respects, it’s an eye-opener. I made the bet for two reasons: (1) to leverage my outlay of $318,250 into a disproportionately larger sum that – if things turned out as I expected – would be distributed in early 2018 to Girls Inc. of Omaha; and (2) to publicize my conviction that my pick – a virtually cost-free investment in an unmanaged S&P 500 index fund – would, over time, deliver better results than those achieved by most investment professionals, however well-regarded and incentivized those “helpers” may be. Addressing this question is of enormous importance. American investors pay staggering sums annually to advisors, often incurring several layers of consequential costs. In the aggregate, do these investors get their money’s worth? Indeed, again in the aggregate, do investors get anything for their outlays? Protégé Partners, my counterparty to the bet, picked five “funds-of-funds” that it expected to overperform the S&P 500. That was not a small sample. Those five funds-of-funds in turn owned interests in more than 200 hedge funds. Essentially, Protégé, an advisory firm that knew its way around Wall Street, selected five investment experts who, in turn, employed several hundred other investment experts, each managing his or her own hedge fund. This assemblage was an elite crew, loaded with brains, adrenaline and confidence. The managers of the five funds-of-funds possessed a further advantage: They could – and did – rearrange their portfolios of hedge funds during the ten years, investing with new “stars” while exiting their positions in hedge funds whose managers had lost their touch. Every actor on Protégé’s side was highly incentivized: Both the fund-of-funds managers and the hedge-fund managers they selected significantly shared in gains, even those achieved simply because the market generally moves upwards. (In 100% of the 43 ten-year periods since we took control of Berkshire, years with gains by the S&P 500 exceeded loss years.) Those performance incentives, it should be emphasized, were frosting on a huge and tasty cake: Even if the funds lost money for their investors during the decade, their managers could grow very rich. That would occur because fixed fees averaging a staggering 21⁄2% of assets or so were paid every year by the fund-of-funds’ investors, with part of these fees going to the managers at the five funds-of-funds and the balance going to the 200-plus managers of the underlying hedge funds.Here’s the final scorecard for the bet:Year Fund A Fund B Fund C Fund D Fund E S&P Index Fund2008 -16.5% -22.3% -21.3% -29.3% -30.1% -37.0%2009 11.3% 14.5% 21.4% 16.5% 16.8% 26.6%2010 5.9% 6.8% 13.3% 4.9% 11.9% 15.1%2011 -6.3% -1.3% 5.9% -6.3% -2.8% 2.1%2012 3.4% 9.6% 5 .7% 6.2% 9.1% 16.0%2013 10.5% 15.2% 8.8% 14.2% 14.4% 32.3%2014 4.7% 4.0% 18.9% 0.7% -2.1% 13.6%2015 1.6% 2.5% 5.4% 1.4% -5.0% 1.4%2016 -3.2% 1.9% -1.7% 2.5% 4.4% 11.9%2017 12.2% 10.6% 15.6% N/A 18.0% 21.8%Final Gain 21.7% 42.3% 87.7% 2.8% 27.0% 125.8%Avg Ann, Gain 2.0% 3.6% 6.5% 0.3% 2.4% 8.5%Footnote: Under my agreement with Protégé Partners, the names of these funds-of-funds have never been publicly disclosed. I, however, have received their annual audits from Protégé. The 2016 figures for funds A, B and C were revised slightly from those originally reported last year. Fund D was liquidated in 2017; its average annual gain is calculated for the nine years of its operation. The five funds-of-funds got off to a fast start, each beating the index fund in 2008. 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. Let me emphasize that there was nothing aberrational about stock-market behavior over the ten-year stretch. If a poll of investment “experts” had been asked late in 2007 for a forecast of long-term common-stock returns, their guesses would have likely averaged close to the 8.5% actually delivered by the S&P 500. Making money in that environment should have been easy. Indeed, Wall Street “helpers” earned staggering sums. While this group prospered, however, many of their investors experienced a lost decade. Performance comes, performance goes. Fees never falter.FROM BUFFETT’S 2018 LETTER TO STOCKHOLDERS:On March 11th, it will be 77 years since I first invested in an American business. The year was 1942, I was 11, and I went all in, investing $114.75 I had begun accumulating at age six. What I bought was three shares of Cities Service preferred stock. I had become a capitalist, and it felt good. Let’s now travel back through the two 77-year periods that preceded my purchase. That leaves us starting in 1788, a year prior to George Washington’s installation as our first president. Could anyone then have imagined what their new country would accomplish in only three 77-year lifetimes? During the two 77-year periods prior to 1942, the United States had grown from four million people – about 1⁄2 of 1% of the world’s population – into the most powerful country on earth. In that spring of 1942, though, it faced a crisis: The U.S. and its allies were suffering heavy losses in a war that we had entered only three months earlier. Bad news arrived daily. Despite the alarming headlines, almost all Americans believed on that March 11th that the war would be won. Nor was their optimism limited to that victory. Leaving aside congenital pessimists, Americans believed that their children and generations beyond would live far better lives than they themselves had led. The nation’s citizens understood, of course, that the road ahead would not be a smooth ride. It never had been. Early in its history our country was tested by a Civil War that killed 4% of all American males and led President Lincoln to openly ponder whether “a nation so conceived and so dedicated could long endure.” In the 1930s, America suffered through the Great Depression, a punishing period of massive unemployment. Nevertheless, in 1942, when I made my purchase, the nation expected post-war growth, a belief that proved to be well-founded. In fact, the nation’s achievements can best be described as breathtaking. Let’s put numbers to that claim: If my $114.75 had been invested in a no-fee S&P 500 index fund, and all dividends had been reinvested, my stake would have grown to be worth (pre-taxes) $606,811 on January 31, 2019 (the latest data available before the printing of this letter). That is a gain of 5,288 for 1. Meanwhile, a $1 million investment by a tax-free institution of that time – say, a pension fund or college endowment – would have grown to about $5.3 billion. Let me add one additional calculation that I believe will shock you: If that hypothetical institution had paid only 1% of assets annually to various “helpers,” such as investment managers and consultants, its gain would have been cut in half, to $2.65 billion. That’s what happens over 77 years when the 11.8% annual return actually achieved by the S&P 500 is recalculated at a 10.8% rate.