Investing Shares

Warren Buffett on Index Funds

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Q:What is Warren Buffett going to do with his money when he can no longer invest it himself?

HINT: It is not what you expect, and it is so simple something you can apply it to your own investment portfolio.

Buffett’s Annual Investor Letter

Every year Warren Buffett writes a letter to the shareholders of his holding company, Berkshire Hathaway.

Buffett’s letter gives a unique insight into the mind of one of the greatest investors of all time and is a must read for anyone with an interest in business and investing.

You can access every letter going back to 1977 HERE

Buffett’s Advice in 2013

Warren Buffett was born in 1930, which means he is getting on in his years.

Being the ever practical and thoughtful investor, Buffett has been outlining his succession plans in the last few annual letters.

In 2013, Buffett even went as far as to outline what he has instructed in his will, which will direct his personal billions (he has already committed to donating 99% of his wealth to charity as part of the giving pledge).

 “My advice to the trustee could not be more simple. Put 10% of the cash in short‐term government bonds and 90% in a very low‐cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, individuals—who employ high fee managers.”

Warren Buffett

Annual Letter 2013, Page 20

warren-buffett-estate-portfolio

Above: Buffett’s Estate Portfolio

What Does Buffett Mean?

To understand Buffett’s instructions, I have extracted another key section of the 2013 letter:

‘’In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.’’

Warren Buffett

Annual Letter 2013, Page 20

Put simply, Buffett is saying is that you don’t need to pick stocks to participate in the growth of the US market – you can just buy the entire market.

Here is a chart of the Dow Jones Industrial Index that Buffett was referring to:

dow-jones-100-years

How Do You Buy the Market?

Before 1975, the only way to invest in the equities (or shares) was to call up your broker and buy a few shares for yourself, or alternatively find a professional money manager who could build and manage a portfolio of shares on your behalf.

The sales pitch of the professional money manager was that they could do better than the ‘man on the street’ because they invested full time and they were so good they could even give you a return that was better than the market (it is just like someone saying they can give you 5% interest on your cash, when the bank is offering 2%).

This style of investment is known as ‘active‘ management:

Def’n: Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index.

Wikipedia

Fast forward to 1975, when along came an enterprising young investor by the name of John Bogle. Bogle reviewed the research and ran the historical performance numbers and decided there was a better way to invest.

Bogle’s bright idea was instead of trying to beat the market, why not just try and get the market return, while keeping the costs as low as possible. Bogle founded a new company, which eventually became the giant Vanguard Investment Group, and started offering his new type of ‘passive’ or index fund.

Def’n: Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio.

Wikipedia

Over the last 40 years’ index funds have grown to represent a big part of the investment industry and are used by both novice and professional investors alike.

An index fund is designed to replicate the performance of a particular investment index.

In other words, an investor is no longer limited to active approaches to investment selection, they can now just opt to buy the index.

markets-on-the-news

There are now thousands of index funds you can invest in globally.

If you want to buy the Japan, China, Taiwan or the US market, you can.

The indexes you can buy on the Australian Stock Exchange HERE

The passive index funds Vanguard offers in Australia HERE

Following Buffett’s Advice

If you want to follow Buffett’s advice you can easily buy the US market in Australia using an ishares exchange traded index fund (‘exchange traded’ means you can buy this type of index fund directly on the stock exchange like a normal share):

ishares-etf-sp500

Each share costs $286 and will give you part ownership in 500 of the top stocks in the US, including Apple, Microsoft, Johnson & Johnson and even Warren Buffett’s company Berkshire Hathaway.

The top 25 holdings are as follows:

ishares-etf-sp500-holdings

The management cost of the ishares S&P 500 ETF is 0.04%, which is very cheap, when you consider that the average investment fund will cost you between 1% – 3% (that’s a minimum of 25 times more expensive).

The only other cost you need to consider is the brokerage cost to buy and sell the shares, which is charged by you stock broker and the ASX.

Is Buffett Right About Index Funds?

As much as the fund management industry tries to hide the fact, Warren Buffett’s advice to invest in an index fund continues to prove to be correct.

Every year, Standard & Poor’s (the company that develops and tracks global investment indexes such as the S&P500 index) reviews the performance of active managed funds and compares this to the index performance.

Here are the latest findings:

spiva-scorecard-2016

These findings tell us that over the last 5 years, only 3 in 10 active managed funds in Australia, beat their benchmark index.

That is not a misprint, 69.18% of professional fund managers underperformed their benchmark (surely weather forecasters have a better strike rate of success).

It certainly makes you wonder why fund managers continue to charge such high fees.

Why Do Fund Managers Underperform?

There is no doubt that there are some very smart investors out there.

The big problem is that we put so many constraints on them, they can’t really outperform the market even if they wanted to.

A common theme amongst investors who have performed exceptionally over the long term, they often raise money from family and friends and they invest their way.

The fund managers who have a track record of beating the index, don’t need your money anymore. Think Michael Burry from the movie and book ‘The Big Short’.

Here are some of the reasons professional fund managers underperform:

  • They find good investment ideas, but often fall in love with these ideas and don’t know when to sell (the disposition effect).
  • The fees on some managed funds are so high, that even when the fund manager outperforms, investors don’t see the returns
  • The structure of a managed fund is inefficient from a taxation point of view, so once again investors don’t see the returns after tax.
  • Fund management is becoming more competitive, so there are far more fund managers fighting for the same ideas.
  • Some funds are so large, that they cannot easily trade in and out of their ideas, thereby restricting their ability to outperform.
  • Fund managers live and die by their performance figures, hence many fund managers would prefer to get average results just so they can keep their high paying jobs.

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

John Maynard Keynes

Where Does That Leave Investors?

Investors are in a great position to follow Warren Buffett’s advice, because, unlike 10 years ago, there are so many index funds available.

The chart below shows the growth of the index fund’s available to investors through the ASX (i.e. you can buy these index funds on the share market – no time consuming application forms are required).

etf-growth

It is almost getting to a point where you name an investment idea and there is an index you can buy.

HERE is that list again.

If your financial adviser or stockbroker is not talking to you about index funds, you should be worried.

Summary

Here are some key points:

  • Buffett has advised that 90% of his estate is invested in a S&P500 index fund
  • Index funds track the performance of stockmarket indexes
  • Index funds provide a broad investment exposure for a very low cost
  • The vast majority of investors will get a better result by using index funds

Have you started using index funds? 

The Wealth Guy Signature

 

Joshua Stega

 

The Wealth Guy

Joshua Stega is an expert financial adviser and founder of JAS Wealth in Sydney. He specialises in the habits and behaviours of wealth. Joshua has a Masters in Taxation and Financial Planning and is regularly featured in the media

M.TaxFP, LLB(Hons), B.Bus(Acc), FTI, Adv.DipFP, Dip.FP, SMSF Specialist
The information on this blog and website is of a general nature only. It does not take into account your individual financial situation, objectives or needs. You should consider your own financial position and requirements before making a decision. We recommend you consult a licensed financial adviser in order to assist you.

 

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