I recently attended a presentation by one of our investment managers to a group of self-directed investors and, as you would expect, the usual question was posed by the audience: “Warren Buffett says you should invest in passive index driven strategies and not with active fee charging managers as they can’t beat the passive index over long periods of time. What are your thoughts on this statement by the world’s best investor?”

​I recently attended a presentation by one of our investment managers to a group of self-directed investors and, as you would expect, the usual question was posed by the audience: “Warren Buffett says you should invest in passive index driven strategies and not with active fee charging managers as they can’t beat the passive index over long periods of time. What are your thoughts on this statement by the world’s best investor?”

I have paraphrased the question above but what ensued was 5 minutes of intense debate with all and sundry trying to get their point of view across. I will try and get my views across and for the record, Mr Buffett, you are wrong. Okay, maybe not wrong but largely misunderstood or misquoted. I present a very simple argument to make my case. Would you rather have invested in Berkshire Hathaway (even on an after company-tax basis) or the S&P 500 over a 10 year period? I would expect that were you to ask Mr Buffett the question, he would give you the same answer every time – Berkshire Hathaway shares.

The debate around the Buffett bet poses a number of interesting intellectual and practical investment questions. It is worth taking some time to review them and attempt to provide you with some answers. Firstly, let’s take a look at the original 2005 assertion by Warren Buffett:

Ted Seides accepted the Buffett challenge and then put together a stupendously stupid bet that, in my opinion, he could not win. He selected 5 fund of hedge funds to compete against a Buffett selected Vanguard S&P 500 low cost index fund. The Longbets original bet and its terms are as follows:

The stupidity of Seides’ bet is quickly apparent when you understand the cost structures of fund of hedge funds. They invest into hedge funds that typically charge fees of 2 and 20. That is a 2% management fee and a 20% outperformance fee. They will also, due to their more complex investment structures, have large expenses which could amount to an additional 2-3% in yearly costs. Over and above the fees of the underlying hedge funds, the fund of fund structure charges an additional fee of 1 and 10, which is a 1% management fee and a 10% performance fee. To put it bluntly they could potential be charging in excess of 8% to 10% in fees per year. That basically guarantees a Buffett victory.

TAMIM’s solution:

While we don’t believe investment decisions should be based on fees, in instances like this where fees are stupidly excessive you should avoid the investment like the plague.

​Buffett states the following in his 2016 report:

So the issue is not that superior mangers don’t exist. They do and Buffett concedes that in his 2016 letter. The issue you face as an investor is how do you find them and avoid the imitators and even more importantly the incompetents! This is where you should rely on trusted advisors to help you.

​TAMIM’s solution:
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At TAMIM we run significant due diligence on the investment managers we works with. We adhere to the following four step process:

We review the managers historical returns – have they been able to do what they say they can do consistently in the past. People will tell you not to look at historical returns but they are wrong. It is our first step. About the only good thing that came out of the 2008 financial crisis is that is gives us a very good benchmark to see how managers performed when the investment world was crumbling around them. If a manager was able to deliver a positive or even a small negative in that period then they are probably worth examining further. The next 3 steps are worth covering in more depth in later articles and they are: obtaining a deep understanding of the managers investment process, understanding the various drivers (economic and otherwise) that will allow this investment process to be successful and finally understanding if those drivers will be present on a forward looking basis.

Size is an issue when managing investments – when managers do well they attract inflows and unfortunately when you manage too much money your returns will suffer. What happens is that managers will have to put more money to work, the small highly lucrative investments they were previously able to make no longer have a meaningful impact on their larger portfolio. As Buffett states in the 2016 letter:

Using the returns from the table on page 1 of the 2016 report we derive the following information. In the first 10 years of operation a $10,000 investment into Berkshire Hathaway was worth $40,097 on book value and $32,341 on market value compared to an investment in the S&P 500 being worth $11,476. Over the last 10 years to 2016, the same $10,000 investment would have been worth $24,508 on a book value basis and $22,165 on a market value basis. The index was comparable at $23,222. Clearly even Buffett found it considerably easier to generate stronger returns with a small sum of money compared to the significant asset he has had to manage in the latter years.

The investment management industry on the whole has much to answer for. They have forgotten one reality. They exist to generate returns for us, their clients. Instead,  these large funds management businesses (most of whom are now owned by the Australian banks), now believe that their business risk is more important than yours.

TAMIM’s solution:

At TAMIM we focus on working with best of breed investment managers who we believe are able to consistently generate you an out sized return. The one key item we insist upon from our managers is that they will never run too much money. All of our strategies are strictly limited in size and in terms of assets they can manage. The following quote from Buffet says it all:

​There will be times where it is appropriate and safe to be investing into low cost index funds but there are other times when this could very well be the riskiest investment you could make. Just look at the return table on the front page of the Buffett 2016 letter. There are times when the index has had significant falls in a given year. In 2008 the index was down 37%. It would be silly and naïve to believe this will not occur in the future, in fact these “Black Swan” events seem to occur more and more frequently.

A person who stopped work in 2008 and took all of their hard earned investments and bought S&P 500 fund or ETF suffered a huge loss. If this person was then required to use the existing savings to live off, they would have had a very difficult or even impossible time recovering and could quite likely run out of money to live off.

We believe, as does Buffet that true active managers exist, if you are amongst the lucky few who are able to find them and access them (they are typically the managers who don’t put up big investor events for 1000’s of people to advertise their prowess) you should be utilising them in your investment portfolios. If you would like to find out more about how we find and research Australia’s best investment managers please contact us for a confidential discussion.