Buffett's Win and the case for Index Funds - Netallianz

Buffett’s Win and the case for Index Funds

That Warren Buffett views the hedge funds industry with skepticism or even disdain is no secret. It was an industry he saw did little more than line their own pockets with exorbitant fees. In his traditional dose of wit and humour, Buffett puts it this way:

If your wife is going to have a baby, you’re going to be better off if you call an obstetrician than if you do it yourself. And if your plumbing pipes are clogged, you’re probably better off calling a plumber. Most professions have value added to them above what the laymen can accomplish themselves. In aggregate, the investment profession does not do that. So you have a huge group of people making — I put the estimate as $140bn a year — that, in aggregate, are and can only accomplish what somebody can do in ten minutes a year by themselves.

- Warren Buffett

The Financial Times tells an interesting story of a the wager between Buffett and Ted Seides of Protégé House in 2006. Protégé is a “Fund-of-Hedge-Funds”, ie a fund that specializes in selecting Hedge Funds for clients to invest now. Hedge funds are expensive, often charging 2% each year of the assets they manage plus a performance fee which can be as high as 20% of the fund’s profits. Fund-of-funds accentuate this problem as they have another layer of fees on top of the Hedge Funds they invest in. In contrast, the S&P 500 index fund that Buffett chose in the wager charged just 0.04%. After a shaky start, Buffett eventually won the bet. Says Buffett:

A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralising, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.

- Warren Buffett

Most (if not all) fund managers are paid based on the size of the funds they managed, so there is a big incentive to grow those funds. But after a certain size, the more money one manages, the harder it is to find sizeable opportunities which can move the needle. Therefore an index fund with a low fee often beats actively managed funds.

Further Reading:
1. Financial Times
2. Royal Gazette