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Warren Buffett has been one of, if not the most, influential and successful investors of our time. His investment company Berkshire Hathaway has delivered a compounding return to its shareholders since 1965 of 19.7%pa and this has been accomplished by adopting a very active investment style. So it is perhaps surprising that his Will asks for his estate to be invested in the S&P 500 Index.
Buffett has long advocated that the index would beat any active strategy over time. He once famously made a $1 million bet with a New York asset manager that any five funds they picked would be beaten by the index after 10 years. It is interesting to consider why such a successful active manager would adopt the view that passive will beat active over time. We see many reasons, but here's just a couple.
The first is that there is only so much alpha (the return above the beyond the market that is sort after by active managers) to go around. The markets are huge, but they are effectively a closed system and so for every 'winner' there has to be a 'loser' in the search for alpha. Now there are some fantastically smart people out there in management land, but one of the problems is these people are not fund managers for altruistic purposes. They want to get paid, and generally very handsomely. There is nothing wrong with that, but it does diminish the returns available above the market return. The second challenge is that as active managers trade in and out of stocks, they incur transaction costs as they buy and sell and tax costs when they sell at a profit. And being active, this activity generally has a higher cost associated with it than a simple passive market investment. Again, this diminishes the amount of their potential out performance.
The result of all this activity is that the number of funds that actually outperform the index is very small. Add to this the fact that past performance doesn't predict future performance and you will have a very hard time picking a consistent winner. So instead of trying to, you can choose a fund of funds approach which invests across a range of managers with different styles and views on the market. Would this make sense? Well, it might, but you are more likely to end up with an expensive equivalent of an index fund.
This makes it sound like an easy decision. And it would be, if there weren't some fund managers who beat the markets for a long time. If you happen to be invested with them, enjoy it but don't fall in love with them. Statistics are not on their side in the long run. Its also probably more a question of luck on the investor's or adviser's part than it is good research. That's not to say there wasn't a lot of work that went into choosing that particular manager but there are just too many variables that go into the manager's performance that are outside of your (and perhaps their) control.
This doesn't mean that we are against taking specific views on companies and/or managers. Some managers may add something to your portfolio that is not easily replicated in an index (whether that is due to a financial, moral or social belief for example). Or the company may have certain characteristics that appear particularly attractive at an attractive price. What we would generally say is that if you're going to act on those views you need to have carefully considered reasons for doing so. Because the likelihood is that for all its foibles the market is a more predictable and dependable choice.