Like Warren Buffett, bet on passive investing.

Back to Money advice
5 June 2018
One of the most famous and successful investors in the world, the billionaire Warren Buffett, is a fan of passive investing.

And when the Oracle of Omaha, as he is known, speaks, investors may as well listen.

His advice to “normal” investors is to invest in low-cost index funds, rather than more expensive active managed funds. “I believe the … long term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers,” he has said.

There is also his famous bet with a hedge fund manager after Buffett issued a challenge to the hedge fund industry in 2007. His view was that these active managed funds performances couldn’t justify the fees that they charged.

Buffett's contention was that, including fees, costs and expenses, an index fund would outperform a hand-picked portfolio of hedge funds over 10 years.

Buffett won the bet.

Buffett bet $1 million that the S&P 500 index fund would outperform a selection of hedge funds over the 10 years. At the end of 2017 this index fund, which tracks the 500 biggest companies in the USA, had returned 7,1% annually over that period, according to Business Insider.

The basket of funds selected by the hedge fund manager, Protégé Partners, only returned 2,1% over this same period.

The evidence in South Africa

Research in South Africa backs up Buffett’s view for investors to also bet on passive investing.

According to the S&P Indices Versus Active (SPIVA) South Africa Scorecard up to June 2017, more than half (55%) of actively managed funds investing in South African equities failed to beat their respective S&P DJI benchmark over the past year. The number of funds underperforming over the five-year horizon increased to 84%.

Active investors struggle to consistently beat the market through smart timing or shrewd stock picking, says Nerina Visser, Exchange Traded Fund (ETF) strategist and consultant to OUTvest.

Indexed funds outperform most active managers, especially on an after-cost and after-tax basis, according to Visser.

Other benefits of passive investing

Passive investing has, beside the returns, other benefits, which includes diversification, transparency and cost efficiency.

According to Visser passive investing is less expensive than other ways of investing “because no active human money manager needs to be paid to make active investment decisions”.

“And because there is less activity when it comes to passive investing, it is also cheaper.”

According to S&P Dow Jones Indices it is typically expensive to compensate active managers and to pay for the frequent trading costs of their buy and sell decisions.

Index funds and ETFs on the other hand tend to change their portfolios only when there is a change in the underlying index - sometimes just a few times a year or even less frequently, according to S&P Dow Jones Indices.

Transparency

Another benefit of passive investing is that it is transparent, which means an investor knows exactly what they are investing in and in what proportion.

An ETF or index-linked unit trust seeks to replicate the performance of the market its underlying index tracks, by either owning all the shares in that index or a representative sample, according to S&P Dow Jones Indices.

The underlying shares or assets that are owned and the proportions are available for an investor to see daily.

This is not the case for actively managed funds. They are required to report their holdings four times a year and between these quarterly filings, these funds can hold any securities and in any proportion.

“So, it’s entirely possible for funds with very different objectives to own a number of the same securities, especially current strong performers, without ever making that information public. For an investor, this can result in duplicative holdings and loss of diversification, which increases investment risk.”

Diversification

Diversification is “having something that zigs when everything else zags”, says Visser.

It also means that you as an investor is not exposed to one investment, one share, or one asset class, but to different shares, different asset classes, different sectors of the economy and even different geographies.

According to S&P Dow Jones Indices a diversified portfolio holds a large number of shares or assets that react differently to changes in the economy or market environment.

When a portfolio is sufficiently diversified, assets that are strong at any given time can help offset losses in those that may be losing value.

Harry Markowitz, the Nobel Prize-winning economist, concluded that the “perfect portfolio” was the whole stock market because it provided the greatest diversification.

Individual investors can attain this level of market diversification by investing in an index-tracking unit trust.

“Today, a portfolio of index-linked products can provide exposure to broad markets either locally or globally. This means investors can come very close to owning the portfolio that Markowitz described,” according to S&P Dow Jones Indices. “Even within a more narrowly defined market, such as an industry or sector, some investors use diversified index products to lower risks relative to investing in individual securities.”

 

 

Sources:
Warren Buffett has won his $1 million bet against the hedge fund industry: http://www.businessinsider.com/warren-buffett-wins-million-dollar-bet-against-hedge-funds-2018-1
Latest Money advice articles
Become an Investor in 4 Easy Steps
OUTvest Market Commentary - June 2022
OUTvest Market Commentary - May 2022