Warren Buffett's annual letter to Berkshire Hathaway shareholders is always a delight to read. Buffett, the Wizard of Omaha, is among the great stock pickers of all time, an investing rarity who has consistently beat the stock market. For instance, shareholders in his holding company have earned a compound average annual gain of 20.8 percent from 1965 to 2016, more than double the performance of the Standard & Poor's 500-stock benchmark index.
You can learn a lot about investing from reading the letter. For instance, he offers an analysis of stock buybacks, why accounting rules on depreciation understate true economic costs, his disdain for management enthusiasm for "adjusted earnings," and insights on the relationship between dividends and taxes. He's also an optimist about the U.S. economy, a perspective in too short supply.
In this column, I want to focus on Buffett's perspective on equity index funds. Buffett rightly argues that the typical investor, say, in a 401(k) and 403(b) will do much better in broad-based equity index funds rather than turning their money over to an actively managed fund.
To prove his point, nine years ago he wagered $500,000 that no investment professional could select at least 5 hedge funds that over a 10-year period would match the performance of a unmanaged Vanguard S&P 500 equity index fund. Ted Seides of Protégé Partners took up the challenge. He picked five fund-of-funds that collectively put money into more than 100 hedge funds. Remember, hedge fund managers are supposed to be the best investors in the global capital markets.
So far, the compound annual increase to date for the index fund is 7.1 percent. For the hedge funds, an average of 2.6 percent. In dollar terms, if you had invested $1 million in the index fund you would have made $854,000 compared to $220,000 in the hedge funds. "The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients," writes Buffett. "Both large and small investors should stick with low-cost index funds."
A theme of this column is the wisdom of indexing, especially for the typical saver putting money into long-term retirement savings. Index funds charge fees that are much lower than the levy on comparable actively managed mutual funds. Index fund investments are more tax efficient for the investor than their actively managed peers.
Chris Farrell is senior economics contributor, "Marketplace," commentator, Minnesota Public Radio.