Warren Buffett Beats Hedge Funds with an Index Fund & Warns Against Debt

If you can keep your head when all about you are losing theirs . . .

If you can wait and not be tired by waiting . . .

If you can think – and not make thoughts your aim . . .

If you can trust yourself when all men doubt you . . .

Yours is the Earth and everything that’s in it.


- Excerpt from If by Rudyard Kipling

The Oracle of Omaha's Annual Letter

In the always celebrated and dissected annual letter to the shareholders from Berkshire Hathaway, CEO Warren Buffett waxes poetic on the current state of financial affairs of his $505 billion (currently valued) conglomerate. Buffet details how his company adds value while staying within their investment principles. He talks in a straightforward manner with no jargon. It’s refreshing to read.


Berkshire Hathaway’s annual growth rate since it formed in 1965 is 20.9%. From 1965 to 2017, Berkshire’s overall gain is a mind-bending 2,404,748%! Compare that to the S&P 500 Index which grew 9.9% annually over that same time and whose overall gain by year end 2017 is 15,508%. One return is average and the other is exceptional.


Despite Berkshire’s amazing performance over 50 plus years, Buffet actually argues that regular investors should stick to investing in a low-cost index fund like the S&P 500 Index instead of striving for outperformance. Why? He believes it’s very difficult to find that diamond in the rough like Berkshire amidst the thousands of other hyped companies to choose from.


I’ll come back to this point later about low-cost index funds, but first let’s talk about what you all came here for: margin loans!

Margin Loans Do What?

Buffet always drops knowledge. This year, he warns investors about using a certain type of debt, called a margin loan, to purchase stocks. A margin loan gives you additional money (and you are charged an interest rate to receive that money - nothing’s free!) to invest by using the stocks you currently own in your account as collateral.


Investors do this to multiply their rate of return when the market is going up without having to put up extra cash. However, when the market tanks, as it did recently, investors can be left owing a lot of money and forced to sell their stock to cover the losses1(Read Footnote 1 for specific examples of how a margin loan can both make you money and lose you money.)


Buffet uses Berkshire’s own stock as an example, showing the four worst losses to Berkshire’s stock averaged -49%, and goes on to say:


“This table [of Berkshire’s negative performance] offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.


“In the next 53 years our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow.


“When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt. That’s the time to heed these lines from Kipling’s If:


‘If you can keep your head when all about you are losing theirs . . .

If you can wait and not be tired by waiting . . .

If you can think – and not make thoughts your aim . . .

If you can trust yourself when all men doubt you . . .

Yours is the Earth and everything that’s in it.’”


The Wall Street Journal recently wrote an article, Investors Zeal To Buy Stocks with Debt Leaves Markets Vulnerable, where they indicated retail and institutional investors reached records levels of margin loans totaling $643 billion this year. This is a lot of gambling:

WSJ - Debt Deluge and Margin Loans
Source: The Wall Street Journal who sourced it from FINRA

The article gives an example of an investor who used margin to buy a type of stock which would rise if stock markets stayed relatively stable. He did this for a terrible reason: “all the strategists agreed the market would go up,” he said. (Breathless commentary.) But then the market took a huge nose dive, and this guy lost $472,000 on his $1.1 million portfolio in a matter of days!


The lesson here is if your advisor provides you the opportunity to trade your account on margin, politely say no thank you. If your brain says you should take the risk, I’d re-read Warren Buffet to remind you of the risks.

WB vs. The Hedgies

Ten years ago, Warren Buffett made “the bet” with a hedge fund manager that a simple index fund following the S&P 500 (the 500 largest stocks listed on the US exchanges) could outperform the returns from five hedge funds.


As a bit of background, a hedge fund is a private investment where investment managers collect money from investors (high net worth individuals, pension funds, institutional investors, and other entities with a lot of money) and then invests that money in companies it believe will provide their investors higher returns than returns by benchmarks such as the S&P 500.


A hedge fund is an investment that is “actively managed”, meaning there is a investment professional making decisions on what companies to invest in and getting paid a fee for doing so. The other side of the coin are “passively managed” investments, which have very low fees because the investments solely replicate an index such as the S&P 500, so there’s no decision on what to invest in, that is dictated by the index the investment is following.


Buffet’s reasoning that the S&P 500 would outperform these hedge funds was as follows (per Berkshire’s 2016 Annual Letter To Shareholders):


“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.


“Subsequently, 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 – stepped up to my challenge.”


Buffett went on to detail what he meant by “massive fees” leaving hedge fund clients worse off:


“The underlying hedge-fund managers in our bet received payments from their limited partners that likely averaged a bit under the prevailing hedge-fund standard of “2 and 20,” meaning a 2% annual fixed fee, payable even when losses are huge, and 20% of profits with no clawback (if good years were followed by bad ones). Under this lopsided arrangement, a hedge fund operator’s ability to simply pile up assets under management has made many of these managers extraordinarily rich, even as their investments have performed poorly.


“Still, we’re not through with fees. Remember, there were the fund-of-funds managers to be fed as well. These managers received an additional fixed amount that was usually set at 1% of assets. Then, despite the terrible overall record of the five funds-of-funds, some experienced a few good years and collected “performance” fees. Consequently, 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.


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


The bet ended in 2017, and it probably comes as no surprise to you at this point that Buffet won the bet - by a lot:

Warren Buffet Beats Hedge Funds with an Index Fund
Source: 2017 Berkshire Hathaway Annual Report

Buffet summarized his victory:


“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 low-cost index funds.”

The Mega-Rich Won't Listen

Buffett isn’t done by just beating hedge funds and telling us we’re all better off by investing in a low-cost index fund, he wants to put the mega-rich on blast. And boy does he.


Buffet believes none (his emphasis) of the mega-rich individuals, pension plans, and institutional funds will follow his advice of investing in low-cost index funds. Buffet says:


“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.


“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. This year the magic potion may be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage:


‘When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.’”


Shots fired! Buffet does offer an olive branch to Wall Street at the end of his write-up, saying he has many friends on Wall Street and that Berkshire will continually pay investment bankers and fund managers outrageous fees for delivering value commensurate with the fees. He’s just going to make the decision of what is commensurate value.

But Wait, Some Investment Managers Beat the S&P 500 Index, Right?

Yes. Every year, many investment managers outperform the S&P 500 Index. But each year, it becomes harder and harder for that same investment manager to beat the S&P 500 Index due to a host of factors (fees, timing, trading costs, taxes, inflows of capital, and so many more).  Eventually, it is very difficult for an investment manager to beat the S&P 500 Index for the long-term (> than 10 years) because of all these factors.


Even though Berkshire Hathaway destroyed the S&P 500 over a 50 year span, the S&P’s returns beat Berkshire’s on 17 of those 53 years, or 32% of the time. Berkshire is also one company of the thousands that investment managers invest in an actively managed fund, so Berkshire’s performance would only move the fund’s returns a bit.


In a study in Jack Bogle’s The Little Book of Common Sense Investing, he reviewed the performance of 355 funds managed by investment managers from 1970 - 2005. Bogle found that only three funds - or 0.8% of the 355 funds - outperformed the S&P 500. As an investor, if you want to take those odds for the long haul, I’d say you should also buy a few lottery tickets.


So stick with being average - just like the indexes. It’ll work out in the long term. And if you’re going to use a financial advisor, make sure that his/her goal is not to outperform the market; instead, your advisor should develop an overall financial plan that over time will include estate planning, retirement planning, education plans for children and family, budgeting, tax-advantaged investing, lending, a continual education in the world of finance, and investments that fit your objectives and risk tolerance. Take advantage of every resource you can get from your advisor because you’re paying for it either way.


Buffet out.

Footnote 1 -

This example of using a margin loan comes straight from the great book by Alan Binder about the financial crisis, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead:


"To illustrate this general principle, consider the contrasting styles of Jane Doe and John Dough:


"Jane, who craves safety, invests $1 million in one-year corporate bonds paying back 6 percent interest. At the end of the year, Jane gets back her $1 million in principal plus $60,000 in interest. Since what she receives is 6 percent more than what she originally paid, her rate of return is, naturally, 6 percent. 


"John, who takes more risk, commits $1 million of his own money to buy those same bonds. But he leverages his investment ten times by borrowing [via a margin loan] $9 million from a bank at 3 percent interest - investing the entire $10 million in the bonds. At year's end, John gets back his $10 million in principal plus $600,000 in interest, or $10,600,000 in total. He repays the bank $9 million in principal plus $270,000 in interest, or $9,270,000 in total. Hence, his net return is $10,600,000 - $9,270,000 = $1,330,000 on a $1 million investment. Thus, John's rate of return is 33 percent - five and a half times as high as Jane's.


"So, is John, who uses leverage, a smarter investor than Jane, who does not? Maybe not. Suppose the bond falls 5 percent in value during the year, and Jane and John need to sell. Now Jane has only $950,000 in principal plus the $60,000 interest, or $1,010,00 in total, for a paltry rate of return of 1 percent. John will get back $9,500,000 in principal plus interest of $600,000, or $10,100,000 in total. But he will still have to pay the bank $9,2700,000 leaving him with only $830,000 of his original $1 million investment. So John's rate of return is minus 17 percent. Now he doesn't look so smart.


"The point is that John's munificent reward on the upside - 33 percent instead of Jane's 6 percent - is not evidence of superior investment talent. It merely compensates him for the risk he takes on the downside - earning minus  17 percent instead of 1 percent. Investors don't reap rewards without taking risk."


Read this a few times to really understand the concept of risk and return, and then you'll understand why Buffet says what he does. You may still say to yourself, "it's still worth the risk to me," and that's fine as long as you understand the potential consequences.