Costs matter!

According to much financial punditry, 2023 was going to be a year that suited active managers. Instead, some 65 per cent of active managers failed to beat their benchmark index in 2023. All managers have the same three tools to manage money: diversification, security selection and timing the market. Using an investment strategy of index funds negates the risks of being held hostage to a manager’s ability or luck, of selecting the right securities, and of consistently timing the market.

Warren Buffet once famously wagered one million US dollars that by investing in the Standard and Poor’s 500 Index (the top 500 US companies by capitalisation) he would obtain a better 10-year return on his capital than Ted Seides, the manager of a sophisticated hedge fund. Buffet won the bet hands down.

A handful of very successful managers also consistently outperform indices, mostly by managing institutional closed-end funds, meaning that the client cannot redeem when they wish. But finding closed-end funds and qualifying for the minimums, typically one million USD, is impractical for most retail investors. The majority of us would be far better off to use broad-based index funds, especially since costs are a big drag on growing capital over time. The annual cost of the Vanguard Total Stock Market Fund (holding all the top large, medium and small US companies by capitalisation) charges 0.05 per cent per annum.

Buffett shared the final scorecard of the bet in his 2017 shareholder letter. The S&P 500 Index fund he selected delivered a total gain of 125.8 per cent during the decade, while the hedge fund reported respective gains of 21.7, 42.3, 87.7, 2.8 and 27.0 per cent during the same period. This decade-long bet challenged the notion that complex and expensive investment methods always yield the best results. After all, anyone can replicate Buffett’s strategy at a very low cost. The Vanguard index fund he picked has an expense ratio of just 0.04 per cent.

“Even if the funds lost money for their investors during the decade, their managers could grow very rich,” Buffet wrote in the shareholder letter. “That would occur because fixed fees averaging a staggering 2.5% of assets or so were paid every year by the fund-of-funds’ investors, with part of these fees going to the managers at the five funds-of-funds and the balance going to the 200-plus managers of the underlying hedge funds.”

In the investing world, fees should not be overlooked – they can eat into your returns. In an op-ed for Bloomberg titled “Why I Lost My Bet with Warren Buffett,” Seides agreed with Buffett about hedge fund management fees. Not only this, but Warren Buffet’s investment strategy for his wife after his death is to place 90 per cent of his capital in the Vanguard S&P 500 index and 10 per cent in short-dated Treasury bills. This should tell us something.

Jeremy Blatch TEP
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