Blog & News | Smartleaf Inc.

The Buffett Bet and the Rise of Passive Investing

Written by Gerard Michael | April 28, 2017

Nine years ago, Warren Buffett bet $500,000 that an index fund would beat a hedge fund basket over a ten-year period.

With one year to go, Buffett’s index fund has averaged 7.1% per year while the basket of hedge funds has averaged 2.2% per year. Buffett’s bet is looking pretty good.*

It’s old news that passive investing approaches are gaining adherents among both investors and wealth managers, but from what we see, passive’s AUM market-share “win” is even greater than it looks. A lot of firms are “tacitly passive.” Publicly, they pursue active strategies, but they’ve adopted simple near-index equity models as their core strategy. These strategies are low cost, tax-efficient and unlikely to dramatically underperform the benchmark. Even adherents of active approaches are de-emphasizing performance, focusing on advice (financial planning, coaching, explanation and counseling) and workmanlike professional services (reporting, oversight, rebalancing and tax management). While there are multiple reasons to become advice-centric, this reluctance by advocates of active investing to tie their fortunes entirely to their stock selection success can be seen as an implicit acknowledgment of the strength of the case for passive investment. Most firms we work with support both passive and active strategies, but in a mark of the decline of the importance firms place on active strategies, this choice is partly just to accommodate client preferences.

At Smartleaf, we serve all styles of wealth managers, but we’ll confess to be biased towards passive approaches. Our focus on taxes and expenses is a natural fit with managers who embrace the low costs of passive investing. ETFs and other index products beat something like 90% of active strategies. What's more (and I may have buried the lead here) is that our clients can consistently beat ETFs on an after-tax basis by using our system to run direct indexes (e.g. 50 stocks that track a benchmark like the S&P 500). We think this is a huge win for investors, and we’re pretty sure Warren Buffett would agree.

 

*You can read more in Berkshire Hathaway’s recent Annual Report in which Buffett recounts the origins of the bet:

“I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?

What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge."

 

For more on this topic, check out Direct Indexes are Better than ETFs.