Why Warren Buffett is Half-Right about Passive Investing

By Robert Bacarella | July 25, 2018

Warren Buffett won his million-dollar 10-year charitable wager that passive would outperform active, as he highlighted in his shareholder letter this spring. In a nutshell, Buffett and a fund of hedge funds called Protégé Partners entered a charitable wager about whether a selection of five funds-of-funds would outperform the S&P 500 Index over 10 years. Read the full letter here.

As Warren Buffett put it in his letter, “the five funds-of-funds got off to a fast start, each beating the index in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index.”

I haven’t been in the investment business as long as Warren Buffett, but in over forty years of observing the industry, I’ve seen a lot—and certainly enough that I’m not surprised Warren Buffett won his bet in dramatic fashion.

Put in context, the significant underperformance of the active managers over the bet’s timeframe isn’t as surprising at it might seem. Consider that, on average, 82% of actively managed U.S. funds have underperformed their benchmarks over the past 15 years. Even worse, large-cap growth managers underperformed 95% of the time.[1]

Those are stark numbers that might push more investors away from active and toward passive. But as the Leuthold Group analysis bears out, active has its place, too.

Active and Passive Cycle In and Out of Favor

Historically, active and passive investment approaches have cycled through periods of favor. Here’s how The Leuthold Group’s Scott Opsal put it: “Active/passive returns will cycle, and the wise investor will avoid concentrating in a winning style during times when it is experiencing unusually favorable weather. ‘Active and passive’ is the right approach.” (Read more.)

Opsal references Callan Associates data that shows four periods when an active approach won out and four periods when passive was in favor from 1991 through 2016:

At this point in 2018, the benefits of passive have been obvious. Many investors have likely seen at least one article questioning the very future of active management. But just when investors think active management is dead it would not surprise me to see active managers outperform a passive approach.  

Market Timing and Investor Behavior  

Investor behavior is also a major issue here. On average, retail investors missed out on a large part of a current bull market because they stepped to the sidelines during the financial crisis and stayed away too long. Market timing based on hunches or fear of losing principal is usually a bad strategy – it may increase your risk level and potentially limit returns.

Statistically, the investor who keeps a steady position, of say, 50% of his assets in the market all the time takes less risk than an investor who is completely in the market half the time and completely out of the market half the time.

For example, a slot machine gambler who makes 20 bets of $5 each takes a lot more risk than a gambler who makes 100 bets of $1 each. Similarly, an investor with 50% of his money in the market for 250 trading days per year takes less risk than an investor with 100% of his money in the market for 125 days and no money in the market for the other 125 days.

These mathematical truisms point toward the benefit of staying invested. So, I believe the best way to look at passive investing is not as a bet against active management but rather as a complement to it. Specifically, passive can complement active investing by providing investors with a degree of performance certainty in that at least part of a portfolio will match the market return.

As for active management, performance risk will vary based on the type of managers selected, i.e., growth or value, small or large-cap. In addition, active managers need to select the best stocks and avoid the worst stocks in order to outperform a passive benchmark, such as the S&P 500 Index.

In other words, active investing is similar to looking for the needle in the haystack, whereas passive investing is buying the haystack. Both are useful and appropriate—so the question is how to combine them in ways that help investors avoid decisions that add risk without expected return.

Implementing a Symbiotic Active and Passive Approach

For some investors, an obvious investment approach is to select one or more index funds (low fees; built-in diversification) and surround these passive funds with a handful of active funds (flexibility to address downturns; outperformance potential). For many investors, a more turnkey approach that combines and automatically shifts between active and passive may be helpful.

Either way, the use of an indexed component is similar to investing a portion of the portfolio on “auto pilot.” A portfolio can be viewed as having a pilot at the controls, where at times an autopilot option is appropriate and at other times a more hands-on approach is warranted, especially during periods of increased market turbulence or when taking off and landing. This symbiotic investment approach may have the effect of providing diversification while minimizing the risk associated with market timing and stock selection decisions.

So, whether it’s a basket of index funds combined with actively managed funds or more of a turnkey option that employs a passive/active approach, the bottom line is that we believe advisors can help their clients by explaining that neither active nor passive is “better”—nor is one a bet against the other.

Investors are most likely to avoid bailing out of the market entirely at precisely the wrong time if they understand how both approaches can work together symbiotically. The objective is to control a client’s risk level by avoiding emotional market timing decisions and lessen dependence of stock selection to enhance returns.

[1] Data from S&P Dow Jones Indices, as of 12/31/16, as reported by CNBC.com: Jeff Cox, April 12, 2017, “Bad times for active managers: Almost none have beaten the market over the past 15 years.”