A big day is coming for the faithful followers of the Oracle of Omaha. Warren Buffett’s annual letter is due out on Saturday, and he’s expected to take up the long-simmering debate about active versus passive investing.
Mr. Buffett has a somewhat complicated relationship with that debate. On the one hand, he is the most famous -- and arguably the most successful -- active manager on the planet. On the other, he has said that 90 per cent of the money he leaves to his wife when he dies will be invested in Vanguard’s S&P 500 index fund -- the archetypal passive investment.
If Mr. Buffett’s faith in active management is shaken, he’s hardly alone. Every six months S&P’s SPIVA scorecard lays out the gruesome results for actively managed mutual funds. In the latest report, 85 per cent of U.S. large-cap managers failed to beat the S&P 500 over 10 years through June 2016. The results are similarly disappointing for small-cap and international stock pickers. Investors have apparently had enough. Passively managed funds attracted $1.8-trillion more than active funds (including smart beta) over the last 10 years through 2016.
I suspect, however, thatMr. Buffett isn’t down on active management, which works; he’s down on active managers, who collect too much in fees.
Index providers such as S&P, FTSE Russell and MSCI have turned traditional styles of active management -- such as momentum, quality and value -- into indexes. Those indexes have historically beaten the market.
The MSCI USA Momentum Index, for example, has beaten the S&P 500 by 3.2 percentage points annually from July 1994 through January, and the MSCI USA Quality Index has beaten it by 2 percentage points annually. The MSCI USA Value Index has beaten the S&P 500 by 0.2 percentage points annually from 1975 through January. (Those are total returns for the longest period that numbers are available.) Those styles of active management have also worked in developed international and emerging markets.
The problem -- as Mr. Buffett is likely to point out in his letter -- is that active management doesn’t work for investors because active managers take most of the profits. According to Morningstar data, the average expense ratio for an actively managed equity mutual fund is 2 percent a year. (I’m referring to C-Class shares because they reflect total fees paid by ordinary investors.) Those fees eat up most -- if not all -- of any outperformance from active management, which explains why so many actively managed funds lose to the market.
So the cost of actively managed funds needs to be a lot lower, but investors’ expectations may have swung to the extreme. Buffett should also point out to investors that fees aren’t likely to decline as much as they hope.
That won’t be easy for investors to hear. They’ve been gouged by active managers for decades, and now they understandably want to pay close to nothing for their mutual funds and ETFs. A new crop of low-cost funds has sprung up to give investors what they want. According to Morningstar data, there are 46 ETFs with a gross expense ratio of 0.1 per cent a year or less.
Those ETFs, however, may be giving investors a false sense of what a portfolio is likely to cost. The vast majority of those ETFs are market-cap weighted U.S. large-cap funds, which isn’t surprising because U.S. large-cap stocks are the cheapest in the world to trade.
But few portfolios are invested solely in U.S. large-cap stocks -- despite Mr. Buffett’s advice to the contrary -- and for good reasons. There are many benefits to investing beyond U.S. borders and across management styles. The most obvious is diversification. There’s also the fact that growth rates -- and therefore expected returns -- are higher in developing countries. And active styles offer the potential to outperform the market, as the MSCI indexes show.
Investors aren’t likely to get those benefits as cheaply as U.S. large-cap stocks. First, trading costs are generally higher outside the U.S., particularly in emerging markets. Active styles, too, often call for buying stocks of smaller companies, which are also more expensive to trade. Second, company data can be sparser and less reliable in some countries, requiring scrutiny from real-life analysts. That scrutiny is particularly important in active styles such as quality and value, which rely on companies’ financial statements. All of those things make operating a fund more expensive.
It’s also worth noting that many firms give away their U.S. large-cap funds and rely on their stable of other funds to make money. As investors continue to press for lower fees, it’s possible that fund companies will raise fees for U.S. large-cap funds at the same time that they lower fees for other ones.
Fund managers and investors will eventually agree on fees. When that happens, I suspect that investors will end up paying a lot less than they do now, but more than they think they should.
Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.Report Typo/Error