8 ms·

I was at the Berkshire meeting this past weekend, and Buffett gave a nice (if simplified) explanation of investing in index funds over active investment, as it

by JamilD 10y ago

I was at the Berkshire meeting this past weekend, and Buffett gave a nice (if simplified) explanation of investing in index funds over active investment, as it pertains to hedge funds, hiring analysts, etc. An excerpt from the transcript [0] follows: What I’d like you to do is for a moment, imagine that in this room, you people own all of America. All the stocks in America are owned by this group. You are the Berkshire 18,000 (or whatever it is) that have somehow managed to accumulate all the wealth in the country. Let’s assume we just divide it down the middle. On one side, we put half the people…half of all the investment capital in the world, and that capital is what a certain presidential candidate might call ‘low energy’. In fact, they have no energy at all. They buy half of everything that exists in the investment world – 50 percent – everyone on this side. Now half of it is owned by these ‘low energy’ people. They don’t look at stock prices. They don’t turn on business channels. They don’t read the Wall Street Journal. They don’t do anything. They are a slovenly group that just sits for year after year, owning half of America’s business. What’s the result going to be? The result is going to be exactly average as all American business does because they own half of all of it. They have no expenses – nothing. What’s going to happen with the other half? The other half are what we call the ‘hyperactives’. The hyperactives’ gross result is also going to be half, right? The whole has to be the sum of the parts. This group, by definition, can’t change from its half of the ultimate investment results. This half is going to have the same gross results. They’re going to have the same results as the ‘no energy’ people but they’re also going to have terrific expenses because they’re all going to be moving around, hiring hedge funds, hiring consultants, and paying lots of commissions, et cetera. As a group, that half has to do worse than this half does. The people who don’t do anything have to do better than the people that are trying to do better. It’s simple. [0] https://www.biznews.com/global-investing/2016/05/02/berkshire-agm-transcribed-buffett-rips-into-active-fund-managers/ https://www.biznews.com/global-investing/2016/05/02/berkshir...

IanCal 10y ago
This can cause an interesting dilemma if you assume that what people invest in makes a difference to the output. It may make more sense selfishly to be in the low-energy group, but the overall returns might be lower the more people go that route. A flawed car analogy: A driver and passenger will both travel the same distance, but the driver spends a lot more effort per mile. So it might both be better for each individual to be low-energy yet better for everyone if people were more active. It's an interestingly complex problem.
- sp332 10y ago
  The passive side gets the same results as the active side (before fees), but the active side determines what the result will be.
- deleted 10y ago
  [deleted]
- e12e 10y ago
  Interesting analogy. I'd say that trains and buses are generally better than cars: arguably we do better with higher efficiency (less effort for similar gain). Why would making "more effort" be better for the value of stocks, if the net result is the same? I would like to think that it is CEOs and boards that manage companies actively, not investors that simply want a certain ROI. In your analogy, I'd say investors are car leasing companies, and it's unclear if they provide a value that can't be just as well provided by the driver(s) buying their cars outright. It would mean that the driver(s) would have to be on more equal footing to the investors, though (they'd have to be able to afford the car).
- marcosdumay 10y ago
  Interestingly, the more bad (under average) investors move to passive investment, the better the average outcome will get. And the more good (above average) investors move there, the worse it'll become. All counted, isn't it great when incentives align almost perfectly with the global optimum?
  - IanCal 10y ago
    Ah but then we come to something I'm going to coin as "Zeno's Investors". Passive investors achieve the average return. Active investors receive some distribution of return but obviously it must range from some above to some below average. 1/x investors get a worse than average return, despite their efforts. For simplicity, let's say that 1/2 of the investors 'win' and half 'lose'. That losing half would do better if they moved to passive investments, allowing the top half to make the real gains. Now, we're back in the same situation. Does this not continue on until it's selfishly best for everyone to be a passive investor, even though overall that might be worse? Ways I think I might be wrong: - The maths doesn't really work quite that way once the balance shifts away from 50% each side. It may be possible that some proportion of active investors will always make more profit than the passive investors. I don't think this is right but if it is then it'd entirely break the reasoning. - Changes that happen from one step to the next. The winners now own more capital and therefore we don't see the same converging series. I don't think that matters other than prolonging the outcome, but I'd not be surprised if I'm wrong on this count, I've not thought it through fully. (I'm trying to be more cautious about making overly bold claims and so am trying to point to things I know might invalidate what I'm saying, if it seems annoying then let me know)
roymurdock 10y ago
This is the danger of only considering averages. Everyone on the passive side gets whatever return the market dictates. In a bad/recession year, this could be largely negative. They are not hedged against business cycle downturns. Different individuals on the active side have wildly differing returns. The guy who invests in the hedge fund with 200% returns doesn't care about the 20, 2 fee structure he has to pay on his investment because he's made so much more than the passive guys. There will be large losers and large winners, but you have to pay table stakes (fees) to play and have your shot at winning those big returns. Buffet is talking his book - a hugely diversified portfolio that basically represents and relies on the strength and growth of the American economy, as well as US government-mandated oligopolies like insurance.
- matt_wulfeck 10y ago
  I hear this mentioned "hedge funds are for downturns" but why is it that hedges were getting demolished going into 2016? If they really do better in downturns then I would have expected better performance from hedge funds as a whole.
  - roymurdock 10y ago
    The term "hedge fund" doesn't really mean anything anymore. It's just an actively managed portfolio with a lower AUM on average than a mutual fund, the legal option to take on more risk, and a certain fee structure. There are a few main investing "disciplines" or "strategies" [1] that each fund manager tends to subscribe to, but it's impossible to talk about them intelligently as a group as they all make wildly diverse bets on different assets across the globe. [1] See figure 3: https://wealth.barclays.com/wealth-management/en_us/home/thought-leadership/Compass/compass-may-15/is-there-a-case-for-hedge-funds.html https://wealth.barclays.com/wealth-management/en_us/home/tho...
- JamilD 10y ago
  > In a bad/recession year, this could be largely negative. They are not hedged against business cycle downturns. This was the argument made by Protege Partners, when betting against Buffett in the great "index funds vs hedge funds" long bet [0]. It turns out that the index funds fared better — and they're mainly used for long-term investment, where the short-term macroeconomic ebbs don't have an impact on the overall return. Of course the variance on the active side will be higher, but there are as many losers as they are winners, and much of it is due to simple randomness. Unless you're confident that you know more than other investors (for many people, including myself, we probably don't [1]), index funds, or "hugely diversified portfolios" are the way to go. Basically, no hedge fund is making those 200% returns you're speaking of, and even if some fund were, empirically it's more likely to be just noise. Look at the result so far of Buffett's bet on hedge funds. It speaks volumes. [0] http://longbets.org/362/ http://longbets.org/362/ [1] https://en.m.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effect https://en.m.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effec...
briHass 10y ago
This is basically a restating of William Sharpe's famous 1991 paper that basically started the whole discussion. "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement." When someone picks active management over passive, they are really betting that they can beat, and hence are not, average. It's difficult for people to swallow their hubris, even when simple arithmetic shows them that they are (collectively) wrong. http://www.cfapubs.org/doi/pdf/10.2469/faj.v47.n1.7 http://www.cfapubs.org/doi/pdf/10.2469/faj.v47.n1.7
- lintiness 10y ago
  when someone picks active management over passive, they're betting THEIR MANAGER can beat the average. people invested in buffett's stock picking skill; how are they doing?
  - zardo 10y ago
    Above average. Of course those people all made an above average choice in active management.
    - cpncrunch 10y ago
      It's somewhat ironic that Buffett is using this analogy, as he made huge profits by being an active investor. You just need to be smarter than the average active investor, which in reality isn't very difficult. The best strategy seems to be to use value investing, which is how Buffett made his fortune. Buy undervalued stocks, then keep hold of them for the long-term (or at least, until they become overvalued, then sell some).
      - briHass 10y ago
        Right, you just buy low, and sell high. It's so simple, I don't know why everyone doesn't do it. In reality, there's nothing statistically inconsistent with a 5 sigma outlier like Buffett.
aakilfernandes 10y ago
The key (absurd) assumption is that 100% of assets are passively-investable.
- hsitz 10y ago
  No, the hypothetical assumes that 50% of all assets are passively-investable. 50% low-energy, 50% high-energy. There are a lot of brilliant, resourceful people in that high energy crowd who are establishing the share prices that the low-energy crowd then gets to take advantage of for nothing. High-energy percentage could likely be much, much less than 50% and passive investing would still work. There is no real danger that so many people are going to turn passive that it won't work; there are plenty of people out there who think they can do better (and always will be, given human nature), despite the evidence that they won't.
  - dragonwriter 10y ago
    > No, the hypothetical assumes that 50% of all assets are passively-investable. No, it assumes that all assets are passively investable, and each asset is half held by passive investors and half held by active investors. Under any other set of assumptions (particularly, if its just a 50%/50% split of initial market value across all but not each individual investment), the equal-returns conclusion does not hold.
  - jrumbut 10y ago
    I don't think the parent posted here meant that passive investors could or couldn't buy up 50% or more of a total market. I believe he meant that active fund managers may be able to get positions or create/use instruments that are not available to the general public.
- RockyMcNuts 10y ago
  Well he does say "To be clear, I’m not arguing that an entire market could ever go passive." Which kinds of begs the question, how much passive investment can there be, and what is the limiting factor, if not a Grossman-Stiglitz model where 'arbitrage ' (in this context market-making, market-timing etc.) makes prices boundedly efficient, and less arbitrage means higher spreads, less liquidity, less pricing efficiency. There must be a 'Bernstein peak' and mixed strategy equilibrium, where if you have too much active, expenses are too high, and if you have too little active, liquidity suffers and costs from spreads and volatility are too high. http://abnormalreturns.com/2016/02/19/the-bernstein-curve/ http://abnormalreturns.com/2016/02/19/the-bernstein-curve/
lintiness 10y ago
it's worth noting that buffett doesn't believe markets are "efficient": "[D]iversification is protection against ignorance. It makes little sense if you know what you are doing."
joncrocks 10y ago
Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices? If you own all of the stock in the US, and no-one actively trades in any single stock, how do you know how much one sort of stock is worth against another piece of stock? I think this eventually drives trading of individual stocks, as the market looks to set prices/trade things this that it thinks are over/under valued. So I think that it's true that on average an active investor will make less money than a passive one, it's the active one's doing the work/generating the value, as well as giving money to the passive investors! (presuming rational actors, laws are obeyed etc etc)
- jcdavis 10y ago
  > Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices? If this stuff interests you, I recommend reading the previous post (http://www.philosophicaleconomics.com/2016/05/passive/ http://www.philosophicaleconomics.com/2016/05/passive/), which discusses this exact topic.
- dragonwriter 10y ago
  > Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices? There is no "correct" price aside from the price set through the market.
- pbreit 10y ago
  I think you're right that there would be a natural balancing. If too many passive dollars went into certain companies, they should become more clearly over-valued than a peer not in the index.
- drumdance 10y ago
  When people withdraw money from an index fund -- say, to put a downpayment on a house or move it into a fixed income fund for retirement -- they are effectively placing a sell order on every stock in the index. And if they put money in from their monthly paycheck, they're placing a buy order. As long there is a reasonably good balance of buyers and sellers of mutual funds, the underlying securities will find equilibrium.
KKKKkkkk1 10y ago
Brilliant. Only a person of the caliber of Buffett can get away with repeating what has been common knowledge since the 1970s and is nowadays written in pretty much every financial self-help book to a rapt audience who record his every word and quote him on Internet forums.
- JamilD 10y ago
  He's not claiming it's new information or something only he knows. In fact he attributes most of his knowledge to Graham. Read some of the other comments in this thread and you'll see it's not common knowledge either.
- drumdance 10y ago
  Index funds were scorned for many years. The first index fund was started by John Bogle in 1976, but he had a difficult time attracting investors. They didn't really become popular until the nineties. This Planet Money episode talks about it in detail. http://www.npr.org/sections/money/2016/03/04/469247400/episode-688-brilliant-vs-boring http://www.npr.org/sections/money/2016/03/04/469247400/episo...
polskibus 10y ago
Wouldn't that be true iif all investing was zero sum game? As far as I know it isn't, at least not in equities.
Dolores12 10y ago
He implies that market will always grow. Lets say we have Japanese market. How do you make money here?
- tonyedgecombe 10y ago
  Dividends?
dragonwriter 10y ago
The fundamental flaw in that argument is the assumption that the inactive and the active groups share of ownership remains the same. Which it would have to only if: (1) the initial split was formed by splitting each company into halves between the two groups, and (2) no new companies were ever formed, or, if they are, they are from initiation split ownership exactly 50/50 between actives and inactives.
bhewes 10y ago
So the tortoise and the hare fable caste as passive vs active investors.

by JamilD 10y ago

IanCal 10y ago

This can cause an interesting dilemma if you assume that what people invest in makes a difference to the output. It may make more sense selfishly to be in the low-energy group, but the overall returns might be lower the more people go that route. A flawed car analogy: A driver and passenger will both travel the same distance, but the driver spends a lot more effort per mile. So it might both be better for each individual to be low-energy yet better for everyone if people were more active. It's an interestingly complex problem.

sp332 10y ago
The passive side gets the same results as the active side (before fees), but the active side determines what the result will be.
deleted 10y ago
[deleted]
e12e 10y ago
Interesting analogy. I'd say that trains and buses are generally better than cars: arguably we do better with higher efficiency (less effort for similar gain). Why would making "more effort" be better for the value of stocks, if the net result is the same? I would like to think that it is CEOs and boards that manage companies actively, not investors that simply want a certain ROI. In your analogy, I'd say investors are car leasing companies, and it's unclear if they provide a value that can't be just as well provided by the driver(s) buying their cars outright. It would mean that the driver(s) would have to be on more equal footing to the investors, though (they'd have to be able to afford the car).
marcosdumay 10y ago
Interestingly, the more bad (under average) investors move to passive investment, the better the average outcome will get. And the more good (above average) investors move there, the worse it'll become. All counted, isn't it great when incentives align almost perfectly with the global optimum?
- IanCal 10y ago
  Ah but then we come to something I'm going to coin as "Zeno's Investors". Passive investors achieve the average return. Active investors receive some distribution of return but obviously it must range from some above to some below average. 1/x investors get a worse than average return, despite their efforts. For simplicity, let's say that 1/2 of the investors 'win' and half 'lose'. That losing half would do better if they moved to passive investments, allowing the top half to make the real gains. Now, we're back in the same situation. Does this not continue on until it's selfishly best for everyone to be a passive investor, even though overall that might be worse? Ways I think I might be wrong: - The maths doesn't really work quite that way once the balance shifts away from 50% each side. It may be possible that some proportion of active investors will always make more profit than the passive investors. I don't think this is right but if it is then it'd entirely break the reasoning. - Changes that happen from one step to the next. The winners now own more capital and therefore we don't see the same converging series. I don't think that matters other than prolonging the outcome, but I'd not be surprised if I'm wrong on this count, I've not thought it through fully. (I'm trying to be more cautious about making overly bold claims and so am trying to point to things I know might invalidate what I'm saying, if it seems annoying then let me know)

roymurdock 10y ago

This is the danger of only considering averages. Everyone on the passive side gets whatever return the market dictates. In a bad/recession year, this could be largely negative. They are not hedged against business cycle downturns. Different individuals on the active side have wildly differing returns. The guy who invests in the hedge fund with 200% returns doesn't care about the 20, 2 fee structure he has to pay on his investment because he's made so much more than the passive guys. There will be large losers and large winners, but you have to pay table stakes (fees) to play and have your shot at winning those big returns. Buffet is talking his book - a hugely diversified portfolio that basically represents and relies on the strength and growth of the American economy, as well as US government-mandated oligopolies like insurance.

matt_wulfeck 10y ago
I hear this mentioned "hedge funds are for downturns" but why is it that hedges were getting demolished going into 2016? If they really do better in downturns then I would have expected better performance from hedge funds as a whole.
- roymurdock 10y ago
  The term "hedge fund" doesn't really mean anything anymore. It's just an actively managed portfolio with a lower AUM on average than a mutual fund, the legal option to take on more risk, and a certain fee structure. There are a few main investing "disciplines" or "strategies" [1] that each fund manager tends to subscribe to, but it's impossible to talk about them intelligently as a group as they all make wildly diverse bets on different assets across the globe. [1] See figure 3: https://wealth.barclays.com/wealth-management/en_us/home/thought-leadership/Compass/compass-may-15/is-there-a-case-for-hedge-funds.html https://wealth.barclays.com/wealth-management/en_us/home/tho...
JamilD 10y ago
> In a bad/recession year, this could be largely negative. They are not hedged against business cycle downturns. This was the argument made by Protege Partners, when betting against Buffett in the great "index funds vs hedge funds" long bet [0]. It turns out that the index funds fared better — and they're mainly used for long-term investment, where the short-term macroeconomic ebbs don't have an impact on the overall return. Of course the variance on the active side will be higher, but there are as many losers as they are winners, and much of it is due to simple randomness. Unless you're confident that you know more than other investors (for many people, including myself, we probably don't [1]), index funds, or "hugely diversified portfolios" are the way to go. Basically, no hedge fund is making those 200% returns you're speaking of, and even if some fund were, empirically it's more likely to be just noise. Look at the result so far of Buffett's bet on hedge funds. It speaks volumes. [0] http://longbets.org/362/ http://longbets.org/362/ [1] https://en.m.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effect https://en.m.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effec...

briHass 10y ago

This is basically a restating of William Sharpe's famous 1991 paper that basically started the whole discussion. "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement." When someone picks active management over passive, they are really betting that they can beat, and hence are not, average. It's difficult for people to swallow their hubris, even when simple arithmetic shows them that they are (collectively) wrong. http://www.cfapubs.org/doi/pdf/10.2469/faj.v47.n1.7 http://www.cfapubs.org/doi/pdf/10.2469/faj.v47.n1.7

lintiness 10y ago
when someone picks active management over passive, they're betting THEIR MANAGER can beat the average. people invested in buffett's stock picking skill; how are they doing?
- zardo 10y ago
  Above average. Of course those people all made an above average choice in active management.
  - cpncrunch 10y ago
    It's somewhat ironic that Buffett is using this analogy, as he made huge profits by being an active investor. You just need to be smarter than the average active investor, which in reality isn't very difficult. The best strategy seems to be to use value investing, which is how Buffett made his fortune. Buy undervalued stocks, then keep hold of them for the long-term (or at least, until they become overvalued, then sell some).
    - briHass 10y ago
      Right, you just buy low, and sell high. It's so simple, I don't know why everyone doesn't do it. In reality, there's nothing statistically inconsistent with a 5 sigma outlier like Buffett.

aakilfernandes 10y ago

The key (absurd) assumption is that 100% of assets are passively-investable.

hsitz 10y ago
No, the hypothetical assumes that 50% of all assets are passively-investable. 50% low-energy, 50% high-energy. There are a lot of brilliant, resourceful people in that high energy crowd who are establishing the share prices that the low-energy crowd then gets to take advantage of for nothing. High-energy percentage could likely be much, much less than 50% and passive investing would still work. There is no real danger that so many people are going to turn passive that it won't work; there are plenty of people out there who think they can do better (and always will be, given human nature), despite the evidence that they won't.
- dragonwriter 10y ago
  > No, the hypothetical assumes that 50% of all assets are passively-investable. No, it assumes that all assets are passively investable, and each asset is half held by passive investors and half held by active investors. Under any other set of assumptions (particularly, if its just a 50%/50% split of initial market value across all but not each individual investment), the equal-returns conclusion does not hold.
- jrumbut 10y ago
  I don't think the parent posted here meant that passive investors could or couldn't buy up 50% or more of a total market. I believe he meant that active fund managers may be able to get positions or create/use instruments that are not available to the general public.
RockyMcNuts 10y ago
Well he does say "To be clear, I’m not arguing that an entire market could ever go passive." Which kinds of begs the question, how much passive investment can there be, and what is the limiting factor, if not a Grossman-Stiglitz model where 'arbitrage ' (in this context market-making, market-timing etc.) makes prices boundedly efficient, and less arbitrage means higher spreads, less liquidity, less pricing efficiency. There must be a 'Bernstein peak' and mixed strategy equilibrium, where if you have too much active, expenses are too high, and if you have too little active, liquidity suffers and costs from spreads and volatility are too high. http://abnormalreturns.com/2016/02/19/the-bernstein-curve/ http://abnormalreturns.com/2016/02/19/the-bernstein-curve/

lintiness 10y ago

it's worth noting that buffett doesn't believe markets are "efficient": "[D]iversification is protection against ignorance. It makes little sense if you know what you are doing."

joncrocks 10y ago

Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices? If you own all of the stock in the US, and no-one actively trades in any single stock, how do you know how much one sort of stock is worth against another piece of stock? I think this eventually drives trading of individual stocks, as the market looks to set prices/trade things this that it thinks are over/under valued. So I think that it's true that on average an active investor will make less money than a passive one, it's the active one's doing the work/generating the value, as well as giving money to the passive investors! (presuming rational actors, laws are obeyed etc etc)

jcdavis 10y ago
> Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices? If this stuff interests you, I recommend reading the previous post (http://www.philosophicaleconomics.com/2016/05/passive/ http://www.philosophicaleconomics.com/2016/05/passive/), which discusses this exact topic.
dragonwriter 10y ago
> Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices? There is no "correct" price aside from the price set through the market.
pbreit 10y ago
I think you're right that there would be a natural balancing. If too many passive dollars went into certain companies, they should become more clearly over-valued than a peer not in the index.
drumdance 10y ago
When people withdraw money from an index fund -- say, to put a downpayment on a house or move it into a fixed income fund for retirement -- they are effectively placing a sell order on every stock in the index. And if they put money in from their monthly paycheck, they're placing a buy order. As long there is a reasonably good balance of buyers and sellers of mutual funds, the underlying securities will find equilibrium.

KKKKkkkk1 10y ago

Brilliant. Only a person of the caliber of Buffett can get away with repeating what has been common knowledge since the 1970s and is nowadays written in pretty much every financial self-help book to a rapt audience who record his every word and quote him on Internet forums.

JamilD 10y ago
He's not claiming it's new information or something only he knows. In fact he attributes most of his knowledge to Graham. Read some of the other comments in this thread and you'll see it's not common knowledge either.
drumdance 10y ago
Index funds were scorned for many years. The first index fund was started by John Bogle in 1976, but he had a difficult time attracting investors. They didn't really become popular until the nineties. This Planet Money episode talks about it in detail. http://www.npr.org/sections/money/2016/03/04/469247400/episode-688-brilliant-vs-boring http://www.npr.org/sections/money/2016/03/04/469247400/episo...

polskibus 10y ago

Wouldn't that be true iif all investing was zero sum game? As far as I know it isn't, at least not in equities.

Dolores12 10y ago

He implies that market will always grow. Lets say we have Japanese market. How do you make money here?

tonyedgecombe 10y ago
Dividends?

dragonwriter 10y ago

The fundamental flaw in that argument is the assumption that the inactive and the active groups share of ownership remains the same. Which it would have to only if: (1) the initial split was formed by splitting each company into halves between the two groups, and (2) no new companies were ever formed, or, if they are, they are from initiation split ownership exactly 50/50 between actives and inactives.

bhewes 10y ago

So the tortoise and the hare fable caste as passive vs active investors.