Should you take Warren Buffett’s advice and opt for index funds?
You may have read the recent comments by Warren Buffet to Berkshire Hathaway shareholders about the merits of active fund management versus index funds. In short, Buffet’s advice for investors contemplating using active managers is: don’t do it; use low cost index funds instead. But is he right?
From my point of view, it is very hard to argue with this as a piece of general advice. If we define active managers as everyone whose portfolio does not resemble the index, the mathematics are inescapable: In aggregate, the population of active managers must achieve returns that equal the market average (ie the index) before costs, and must underperform the index after costs.
If you are providing advice to the population as a whole then, it clearly makes sense to favour index investing as the most efficient solution.
The problem gets a bit more interesting, however, when you look at the position of an individual investor. Some investors clearly do have the ability to beat the market, and if you are one of those investors – or can identify a manager who is, then it makes sense for you to pursue active management.
Berkshire Hathaway is an obvious example. Berkshire clearly practices active investment management every day, presumably having satisfied itself that Buffet, Munger and the broader Berkshire investment team have the ability to do better than an index. There is some historical evidence that supports them in taking this view.
It is fair to say, however, that the challenge of beating the market is a formidable one, and one that a lot of investors underestimate. A great many of these investors would no doubt be better served by following Buffet’s advice and investing in the index in preference to using actively managed funds.
Present company excluded, of course!
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
lakun agrawal
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Would Montgomery Fund be willing to put its “money where its mouth is” and guarantee at least the market index performance? I think this would be a great innovation in the investment landscape.. otherwise as investors we are taking a ‘punt’ that our chosen active manager will do a good job with our money, and if they don’t.. well they still get paid commisisons but as investors we lose our capital.
My suggestion is to offer the prospective investor a deal.. Montgomery should guarantee at least achieving index performance after costs (so no risk of market underperformance to the investor).. in return Montgomery should take a much large commission for outperforming the market. Eg if normal commissions are 1.5%, charge 3.0% instead (so long as at least market index performance is met).
This way, the active investor’s interests and hip pocket is truly aligned with their customer.
Roger Montgomery
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We did discuss a fund once with a zero fee and a larger percentage of all positive returns. Too unconventional for the market to accept I am afraid. The structure you suggest would probably see many fund managers head towards market hugging and the collection of massive inflows.
Max Zan
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I recently read an article that stated the ASX All Ords Accum Index returned on average 10% pa over the past 104 years . So if you invested in an Index Fund tracking that index and reinvested your dividends a similar return would have been achieved That’s no bad but will it continue??? I’m not sure it will as that Index is heavily weighted with mature companies that will struggle to grow in this low growth environment and PE expansion due to low interest rates has stretched valuations. Picking individual stocks that will do well is what it’s all about – I’m confident the Montgomery team are skilled at Investing in Businesses with good growth prospects, however in recent times that confidence has been stretched. Being a successful Investor involves knowing when it’s time to buy and when to sell whether it be Index Funds or Actively Managed Funds. It’s easy for an Individual investor to pick buy and sell points as little funds are involved but that’s difficult for Fund managers to do when they manage hundreds of millions of dollars so are affected when stock prices turn down. Every Investment structure has it’s place at a point in time and I recommend a mixture of styles as that mitigates risk .
Charlie Dalziell
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I’m sure Warren would support an investment in the Montgomery Fund. An investment in a high fee “absolute return” fund with performance fees payable over a benchmark of the US 10 year bond rate? Well……..!
Carlos Cobelas
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You are incorrect. The Montgomery fund does not charge performance fees for beating the bond rate. Perhaps you are thinking of the Montaka long short fund.
Brett Edgerton
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Yep… and unlike Buffet’s advice to the masses, he and Munger also time the market- on an individual stock basis – this is implicit in his comments that he is running the ruler over businesses all of the time to see whether their prices make sense to purchase… And even though he constantly says he does not know what the market as a whole will do today, tomorrow, next week or even next year, he always has hordes of cash in the full knowledge that Mr Market will throw up brilliant buying opportunities from time to time (a la 2009) of which he can take full advantage…
I watched Buffett on Monday night on CNBC and here is a direct quote:
“The amount of money people have wasted on getting investment advice, it’s just ridiculous in this country”…
So the question remains to be answered – why is Australia different? – why is Montgomery different?
Any manager that bunkers down and does not come up with a good response – and just hopes for it all to blow over – is not worth investing in, in my book…
I have expanded on this in my further comment to Roger in his latest whitepaper which points to failings of “investors”…
Chris
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Today’s Australian Newspaper (Business Section), page 24, Bottom.
Buffett increases his stake in Apple, draw the parallel with the column a few weeks ago.