December 6, 2021

StrategisChhr

Skillful Business Crafters

The power of passive investing: time to relearn lessons

The spring weather in Omaha can be brutal. Luckily, it was an unusually pleasant day when Carolyn Williamson, a matronly woman with cropped silver hair, a striking yellow cardigan and red-rimmed glasses clipped the ribbon strung across the doorway of Protégé House.

The dowdy brick building just north of Omaha’s centre was once a convent. On April 10, 2019 it was reopened by the charity Girls Inc as a house for troubled women too old for foster care but young enough still to need a supportive home. In many respects the ribbon-cutting was unremarkable, yet the genesis of Protégé House was far more momentous than the humdrum setting indicated.

The money to run the programme came from Protégé Partners, a New York investment firm that had lost an epic, decade-long wager with Omaha’s most famous resident: the multibillionaire investor Warren Buffett. And this was a bet with implications far beyond a repurposed convent in sleepy Omaha — with a moral that is particularly poignant today.

Over the past year financial markets have been convulsed by one of the most violent spasms of retail trading in history. Cooped up at home by the pandemic, millions fired up brokerage accounts for the first time, tuned in to stock-tipping TikTok stars, logged on to Reddit’s profane WallStreetBets forum and had a blast.

However, investing is a rare walk of life where it actually pays to be a little bit lazy and not overthink things, as shown by Buffett’s million-dollar wager with Protégé Partners.

Here is the inside story of how the investment industry’s bet of the century came about, how the Oracle of Omaha trounced his opponents, and the enduring lesson that it still holds for ordinary investors who think trading is a quick way to riches.

Buffett’s challenge

CNBC was blaring in the background when Ted Seides settled into his 15th floor corner office in New York’s MoMA building to work through his overflowing email inbox. There he spied something intriguing.

It was the summer of 2007 and a friend had sent the transcript of a meeting between Buffett and some college students. In it, the famed investor mentioned that no one had dared enter a wager he had offered a year earlier, that even imperious hedge fund tycoons couldn’t beat the US stock market. The scorn vexed Seides. After all, hedge funds were his bread and butter.

Winning wager: Warren Buffett, the ‘Oracle of Omaha’ © Johannes Eisele/AFP/Getty Images

A few years earlier Seides had helped found Protégé Partners, a “fund-of-funds” that specialised in unearthing the industry’s most skilled financial wizards for other big investors. By 2007, Protégé managed $3.5bn and had handily beaten the returns of the US stock market.

This was the heyday of hedge funds, which by 2007 managed nearly $2tn. Big hedge fund managers such as George Soros had amassed vast fortunes, attracting envy even in other well-paid corners of finance. By the mid-noughties, most young Wall Streeters dreamt of running a hedge fund, not toiling away in investment banking or — perish the thought — doing unglamorous work such as lending money to companies.

This frustrated Buffett, who had long felt the investment industry overflowed with mediocrities who did little more than line their own pockets with the ample fees they charged clients. He gave it both barrels at Berkshire Hathaway’s annual meeting in 2006.

“If your wife is going to have a baby, you’re going to be better off if you call an obstetrician than if you do it yourself. And if your plumbing pipes are clogged, you’re probably better off calling a plumber. Most professions have value added to them above what the laymen can accomplish themselves. In aggregate, the investment profession does not do that,” Buffett griped. He therefore offered to bet that a fund that simply tracked the US stock market would beat any crew of fancy hedge fund managers over the next decade.

Investment vehicles that simply mimic market benchmarks rather than try to beat them are known as “index funds”, and the approach is often dubbed passive investing because of its hands-off nature. Since there is no research involved, index funds are usually cheap, often costing a tenth of a traditional mutual fund, or even one hundredth of what some hedge funds charge.

However, the proposed wager looked silly to Seides. As CNBC was trumpeting in his office that morning, the subprime mortgage crisis had just begun to rumble. Seides rightly reckoned that things would get worse before they got better. The hedge fund industry’s freewheeling buccaneers looked like they would be far more adept at navigating the coming storm.

After all, hedge funds can profit from markets both rising and falling, and invest in far more than just the S&P 500 index of US stocks that Buffett had offered up to fight his corner. Since it was a slow day, Seides wrote an old-fashioned letter to Buffett, proposing to accept the wager.

To his delight, Buffett promptly replied, scrawling a terse message on Seides’s letter and sending it back to his New York office. Each party ponied up about $320,000, which would be used to buy a Treasury bond that would be worth $1m at the bet’s conclusion in 2018. If Protégé won, the proceeds would go to Absolute Return for Kids, a charity backed by the hedge fund community. If Buffett triumphed, the money would go to Girls Inc.

Initially, it looked like Buffett would have to eat some humble pie. While the hedge funds lost over 20 per cent in 2008, the index fund chosen by Buffett tumbled by 37 per cent. It looked like Seides’s argument that hedge funds would do a better job in a bear market was bearing fruit. Would it hold?

The lauding of Jack Bogle

In December 2016, Jack Bogle received an enigmatic note from an old friend asking him to block off the first weekend of next May, when Bogle would be turning eighty-eight. Steven Galbraith, a former Morgan Stanley strategist, wanted to do something special to celebrate his octogenarian friend, but refused to tell Bogle what he had cooked up.

Four decades earlier, Bogle had founded Vanguard, an investment group that brought index funds to the masses. Indeed, it was a Vanguard fund that Buffett had chosen as his champion in his bet with Seides — a bet whose victor would coincidentally be declared around Bogle’s birthday.

On the morning of May 5 2017, Bogle and his family drove from their house in Bryn Mawr to Philadelphia’s private airport, where a jet picked them up and flew straight to Omaha. Bogle was to attend his first-ever Berkshire Hathaway annual shareholder meeting.

The event is often called the Woodstock of capitalism, a forum for anyone who owns a share in Berkshire Hathaway to ask Buffett and his partner Charlie Munger about everything from business to geopolitics. The duo revel in the attention, Buffett responding with his well-honed folksy wit and Munger with terse acidity.

Index tracker king: Vanguard founder Jack Bogle © Shannon Stapleton/Reuters

As entertaining as it was, Bogle began wondering why Galbraith had brought him all the way to Omaha at his advanced age and poor health. But then Buffett made a sudden detour, and all became clear. “There’s one more person that I would like to introduce to you today and I’m quite sure he’s here. I haven’t seen him, but I understood he was coming,” Buffett said, scanning the audience. “I believe that he made it today and that is Jack Bogle . . . Jack Bogle has probably done more for the American investor than any man in the country. Jack, could you stand up? There he is.” 

To thunderous applause, the gaunt but beaming Bogle stood up, waved to the crowd, and took a small bow toward Buffett and Munger’s podium.

To attendees who might not know who the old man might be, Buffett explained how index funds like those offered by Vanguard had upended the money management industry. “I estimate that Jack, at a minimum, has saved and left . . . tens and tens and tens of billions into their pockets, and those numbers are going to be hundreds and hundreds of billions over time,” Buffett said. “So, it’s Jack’s eighty-eighth birthday on Monday, so I just (want to) say, ‘Happy birthday, Jack.’ And thank you on behalf of American investors.” Another round of hearty applause broke out in the arena.

For Bogle, being lauded by the famed investor in front of thousands of people was immensely emotional. He died in January 2019, one of the finance industry’s rare mainstream heroes. But for Buffett, Bogle’s visit was akin to a victory lap. Just days before the shareholder meeting, Seides had officially conceded that he had lost the bet. In the end, it wasn’t even close.

The Vanguard 500 index fund had returned 126 per cent over the decade. The quintet of funds-of-hedge-funds chosen by Protégé had made only 36 per cent. In his annual report, Buffett was not above some gloating.

“Bear in mind that every one of the 100-plus managers of the underlying hedge funds had a huge financial incentive to do his or her best,” he wrote. “I’m certain that in almost all cases the managers at both levels were honest and intelligent people. But the results for their investors were dismal — really dismal.”

The long game

Data is a hard taskmaster and consistently shows that while some fund managers might get lucky for a few years, very few do well in the long run. The exact statistics vary between different types of financial markets, but roughly speaking, only 10 to 30 per cent of active funds beat their benchmarks over any rolling 10-year period after fees. Over the past two decades, just 6 per cent of US stockpicking mutual funds have beaten their benchmarks.

This is why the index fund industry has exploded in recent years, and today controls about $17tn, according to Morningstar. The biggest equity fund in the world is today an index fund. The biggest bond fund as well. The leading gold ETF now holds almost 1,000 tonnes of the yellow metal — more than most central banks.

Although seemingly frivolous, friendly gambles can have a lot of power. In 1600, Johannes Kepler, the German astronomer, bet a Danish rival that he could calculate a formula for the solar orbit of Mars in eight days. In the end it took him five years of toil, but Kepler’s work helped revolutionise astronomy. Buffett’s bet is a modern-day testament to how even professional money managers stuffed with PhD economists and computer scientists often do a mediocre job of investing, and the odds on ordinary people doing well are infinitesimally low.

However, the central lesson imparted by the wager is already in danger of being forgotten.

Meme stonk and ‘boomer spam’

Locked down by the coronavirus and stoked by financial memes, gamified trading apps and the evaporation of commissions, millions took to day trading with gusto. Undeniably, many have done well, anticipating and riding the stock market rally with more aplomb than even the Oracle of Omaha himself.

“I’m sure Warren Buffett is a great guy, but when it comes to stocks he’s washed up. I’m the captain now,” Dave Portnoy, the day-trading founder of website Barstool Sports triumphantly declared last summer, when the retail trading frenzy started blossoming into full-blown euphoria.

In some cases — most notably in the “meme stonk” craze of early 2021 — they were even able to deliver a black eye to some hedge funds directly, by pumping up stocks like video games retailer GameStop that hedge funds had bet would fall.

Yet in many respects, this represents a perversion of Buffett’s central point. Yes, even professional money managers on average do a poor job, but the new generation of retail traders think the answer is to play the game themselves, rather than opt out and invest in a handful of broad, boring index funds.

“No one ever got extraordinary results doing mediocre things,” one Reddit user on the now-infamous WallStreetBets forum said in a discussion on how to counter dull advice to invest in passive funds. “I want to drive my lambo now, not when I’m so old and senile I won’t even be allowed to,” another said. When someone dared to post an interview with Bogle talking about index funds, one user immediately dismissed it as “boomer spam”. 

Unfortunately, study after study has shown that the overwhelming majority of ordinary people that try their hand at trading do a miserable job. And the more hyperactive they are, the worse they do.

One comprehensive study of Brazilian retail investors found that 97 per cent of those that had traded on at least 300 days across 2013-15 lost all their money. Only 1.1 per cent made more than what they would have working at their local McDonald’s, and only 0.5 per cent earned more than an entry-level bank clerk.

The reality is — a few black eyes aside — no one is happier about the explosion of retail trading than professional money managers, stock exchanges, brokerages and high-speed traders. There is a reason why ordinary investors are usually referred to as “dumb money” by finance industry insiders, marks to be picked off over time. Meanwhile, swaths of the industry detest index funds.

The boons are being reaped by nearly everyone — both directly and indirectly. US investors in index funds have saved $357bn in fees over the past 25 years, S&P Dow Jones calculates. But the bigger impact is the broader pressure that competition from passive funds have had on virtually all investment fees. The average cost of US mutual funds has shrunk by a third over the past two decades. That is money that has gone straight into the pockets of savers, rather than Wall Street.

Given the impact of social media, swish mobile phone apps and free trading platforms — either nascent or non-existent during the dotcom boom — the resurgence of retail trading is likely to prove more durable than previous bursts of hyperactivity. Yet in the fullness of time the enduring lesson of Buffett’s bet will eventually shine through once more — as even some of the more self-aware self-described “apes” and “degenerates” of WallStreetBets glumly admit.

 “Last time I check (sic) he was the Oracle of Omaha, not the day trader of Omaha. He will once again humble us all in the long term,” one Reddit user observed.

The author is FT Global Finance Correspondent. The article is adapted from his book ‘Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever’

Letter in response to this article:

Recalling Samuelson’s gunslinger challenge / From Andrew McKechanie, Edinburgh, UK

https://www.ft.com/content/17b2127b-2548-4c15-bf34-056b49793ba2