Could the “Oracle of Omaha” possibly be wrong?

07.03.2017 09:30|Conotoxia.com

Warren Buffett, one of the richest people on the planet, advised investors to avoid actively managed funds: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap oversized profits, not the clients”. It’s hard to dispute his reasoning - although, are actively managed funds always a losing choice? - writes Bartosz Grejner, Cinkciarz.pl Market Analyst.

Bartosz Grejner, analityk Cinkciarz.pl

Buffett, known from the media as the “Oracle of Omaha” is, according to the most recent Forbes data, the second-richest man in the world (as of the end of February). His wealth is estimated at 76.3 bn USD, 10 bn less than Bill Gates. Every year, for over half and decade, Buffett has been writing a letter to Berkshire Hathaway shareholders that’s also publicly shared. This year he did so on the 25th of February. In his letter, he advises investors both small and big to stick to index funds (passive) which tend to be low in costs compared to those actively managed.

Will Buffet win one million dollars?

It wasn’t the first time when Buffett demonstrated such a confidence in funds that track indices. He was so sure of his belief that during the financial crisis in the U.S., he bet on one million dollars with the Protege Partners fund that the fund that tracks the S&P500 index (Vanguard) will achieve a better rate of return during the 10 years period than the group of freely picked five funds. The bet will end on the 31st of December this year and from Buffett’s letter, we learn that the mentioned group of funds would achieve 220k USD of return (out of a 1 mn USD investment) while the index fund would earn 854k USD. Buffett’s win is almost certain now and profits from the bet will go to charity.

According to the “Oracle of Omaha” the reason behind the somewhat limited return of those funds lies in the costs that their client incur. In the letter to his shareholders, he estimated that 60% of return from the mentioned five funds went to the people who managed them, even though they performed worse than the whole index. However, the actively managed funds still dominate on Wall Street. According to Bloomberg data, they managed 5.14 trillion USD while passively managed only 4.26 trillion USD. The difference has been getting smaller and smaller, though. In 2016 r. actively managed funds noted an outflow of 340 billion USD while 505 billion USD flowed into passively managed funds.

It’s hard to dispute Warren Buffett’s arguments. Ultimately, the 86-year old billionaire has experience, knowledge and accomplishments as an investor. However, actively managed funds not always have to be worse than their passive counterparts.

What is active and passive managing?

Actively managed funds focus on beating the market, i.e. a specific set index (benchmark), which results could be related to. It means that we rely on the knowledge, experience and skills of the managers in selecting assets (including shares, commodities, bonds) which could prove the most profitable. The main, however only potential, advantage of this approach is the possibility of achieving a greater return than the whole market (index).

It’s possible not only due to greater freedom in picking the right assets but also in choosing the right financial instruments at the time (e.g. options or future contracts). With their help, one can hedge against losses when the market turns red. Additionally, an active strategy allows for a swift exit out of particular positions or sectors of the economy that could be currently in a worse condition. Managing taxes could be more flexible as well – for example selling positions with losses just before the year’s end could reduce the tax burden for an investor.

On the other hand, one has passively managed funds. In a nutshell, it means reproducing as precisely as possible a particular index. In other words – when a Bank X has a 14.4% share in the Polish WIG20 index, the share of Bank X in the passively managed fund based on WIG20 should also be 14.4%. This very simple construction methodology eliminates the main risk – and potential benefits at the same time – of human involvement in the process of managing a fund. That’s why funds that implement such a strategy will virtually always have lower costs – which is one of Buffett’s main arguments in favour of such funds. Furthermore, lower costs also stem from a significantly lower frequency of transactions, except those needed to adjust the changing weight of shares in the benchmark index (WIG20), because ever changing prices also change companies valuations and in effect their share in the index.

Which type of fund to chose?

Investors have been asking themselves the same question for several decades now and still haven’t reached a definitive answer. Simple logic suggests that passively managed funds could prove a less risky option because the human factor is eliminated. We could always relate to the words of the “Oracle of Omaha”. In his letter to shareholders for the year 2014 Warren Buffet wrote that in the case of his death, we will put 90% of the wealth left to his wife into a passively managed S&P500 index fund (Vanguard) and 10% in government bonds.

 


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