Since I gave up politics for Lent this year, I’ve had more time to keep up with the deeper recesses of the financial press, which led me to Warren Buffett’s annual letter to the shareholders of Berkshire Hathaway. Buffett’s prose is a literary genre unto itself; a remarkably plain-spoken approach to making even the most complex and dull aspects of investment management simple and entertaining. If all “management letters” were penned as well, shareholders might actually read them. Perhaps that’s why they aren’t.
Press coverage of Buffett’s letter this year focused almost exclusively on the sections extolling the virtues of passive investing. Buffett updates us on his million dollar bet that a selected group of hedge funds won’t beat the S&P 500, after fees, over a ten year period; nine years in he’s winning handily. He nominates Jack Bogle for sainthood, and bemoans that wealthy people have squandered an estimated $100 billion (his estimate) on elaborate investment strategies that haven’t been as effective as index funds. In one of the more colorful passages in the letter, Buffett tells a family story that, while not directly addressing investment performance reporting standards, could be interpreted that way:
Long ago, a brother-in-law of mine, Homer Rogers, was a commission agent working in the Omaha stockyards. I asked him how he induced a farmer or rancher to hire him to handle the sale of their hogs or cattle to the buyers from the big four packers (Swift, Cudahy, Wilson and Armour). After all, hogs were hogs and the buyers were experts who knew to the penny how much any animal was worth. How then, I asked Homer, could any sales agent get a better result than any other?
Homer gave me a pitying look and said: “Warren, it’s not how you sell ‘em, it’s how you tell ‘em.”
Buffett’s story could be the forward to the next edition of GIPS Standards; all you need is the right benchmark.
All of this is, of course, a little hard to take from Warren Buffett. Not only has he made a (very successful) career out of asset management, he has previously been emphatically against spreading investment bets across too many assets – as one would in an index. Buffett and his longtime partner, Charlie Munger, have more than once characterized such breadth as “di-worse-ification.” Munger’s famous quote about bad mergers – “If you mix raisins with turds, they are still turds” – could equally apply to index investing, where the algorithm is to overweight Blockbuster and underweight Netflix. Despite a lengthy and successful career focusing on a few investments, Buffett appeared to have changed his mind.
Predictably, there has been plenty of umbrage taken by the investment management community over the past week because of this. It doesn’t help that Moody’s latest quarterly Investors Service report tallied continued outflows from active managers in the fourth quarter of 2016. However, I’m not sure that this is the right time for portfolio managers to beat their chest and defend their alpha. For all of Buffett’s broadsides, this year’s letter is practically an apologia for active management.
By my count, Berkshire Hathaway has beaten the S&P 500 in 34 of its 52 years, but more impressive than winning two thirds of the time is the order of magnitude. While the S&P 500 has produced a total compound annual return of 9.7% since 1965, Berkshire Hathaway has produced more than double that return, at 20.8%. Thanks to compounding, the aggregate return of Berkshire is 155 times that of the index. That’s a lot of alpha, and it isn’t just restricted to the early years. Berkshire has beaten the S&P 500 in seven of the last ten years, producing an average return 2.1% better than the index, and doubling the index return last year.
The bulk of Buffett’s letter endorses active management. Berkshire Hathaway morphed over time from a stock-picking firm to one that also wholly owns businesses (the extreme end of active management). Consequently, when Buffett is particularly proud of one of Berkshire’s investments, he takes great pains to praise the humans who run those businesses. In particular, Buffett notes the accomplishments of his insurance company management teams who make profits out of managing underwriting risk and superior investment performance off of those companies’ float. And, as usual, Buffett gloats on Munger, noting that regardless of the future developments of artificial intelligence: “I will confidently wager that no computer will ever replicate Charlie.”
The bulk of Buffett’s criticism of the hedge fund industry focuses on fees. He estimates that approximately 60% of the gains produced by the five hedge funds be measured against the S&P 500 were allocated to the fund managers. The issue seems not so much the value of humans in investment management, but the cost.