Berkshire Hathaway Chief Executive Warren Buffett and Vice Chairman Charlie Munger excoriated Wall Street last weekend at the company’s annual meeting in Omaha. The two legendary investors focused much of their ire on hedge funds, an investment option largely restricted to the very well-heeled. Still, their message should resonate with anyone putting money every month into a retirement savings plan, such as a 401(k) and 403(b). Get rid of expensive, actively managed mutual funds and embrace broad-based low-cost index funds instead.
Buffett backed his disdain for hedge funds with a wager he made eight years ago. Buffett made a 10-year $1 million bet that the Vanguard Standard & Poor’s 500 index fund would beat a portfolio of hedge funds picked by the boutique asset management firm Protégé Partners. Performance would be measured “on a basis net of fees, costs and expenses.” The money goes to charity. The return on the hedge funds in the eight years through 2015 was 21.9 percent. The return on the S&P 500 index fund, 65.7 percent.
Buffett and Munger are right to emphasize that Wall Street hasn’t done well by the average worker saving for their retirement. Actively managed mutual funds have systematically underperformed passively constructed index funds. The performance gap largely reflects the higher fees charged on actively managed funds compared to index funds.
Investing is probably the world’s most competitive business. Money managers find it tough to consistently gain an edge, thanks to intense competition from hordes of individual investors, mutual fund money managers, hedge fund financiers, corporate treasurers, pension fund managers and others. Systematically identifying and taking advantage of value gaps in the market over time is hard — really hard. Yes, Buffett and Munger share a rare combination of skill, talent and luck. Most professionals in the market don’t have what Winston Churchill called the “seeing eye.”
Here’s the thing: With broad-based index funds you know you’ll pay razor thin fees to participate in the dynamism of America’s publicly traded companies that comprise the market index, such as the S&P 500 and the Russell 3000. You’ll do as well as the market index, minus low fees which means, in turn, that you’ll leave most professionals money managers in the dust. Buffett called this insight “probably the most important investment lesson in the world” at the annual meeting. He’s spot on.
Chris Farrell is senior economics contributor, “Marketplace”, and commentator, Minnesota Public Radio.