Warren Buffett On Active vs. Passive Investing, Outlines 'The Bet' In Berkshire Shareholder Letter

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Warren Buffett, billionaire fundamental investor and CEO of Berkshire Hathaway BRK.B , released his annual report to shareholders outlining "The Bet". Nine years ago, Mr. Buffett publicly bet that any set of five hedge funds could not outperform the S&P 500 index over a 10 year period of time; hedge funds charge high active management fees while the S&P 500 index is invested in through low cost index funds. Ted Seides, co-manager of Protégé Partners, stepped up to the plate against Mr. Buffett.

Mr. Seides chose five funds-of-funds, which invest in a variety of hedge funds, and Mr. Buffett decided on a Vanguard S&P 500 index fund. The wager counted performance net of fees, costs and expenses which boils down Mr. Buffett's thesis of his bet: passive investing will outperform active management in the long run because costs strip away high performance possibilities.

Sure enough, to date, Mr. Buffett is ahead in the race and declared victory. The wager began on January 1, 2008 and will end on December 31, 2017. Through 2016, the compounded annual increase for the Vanguard index fund is 7.1% and only an average of 2.2% for the five funds-of-funds.

In his letter, Mr. Buffett writes, "The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients."

It is important to note that Mr. Buffett is not saying it is impossible to outperform the market. He prides himself on his ability to pick winning investments over losing investments. What Mr. Buffett is pointing to is that most active managers will fail; he states that more than $100 billion have been drained into badinvestment advicein the past 10 years.

Berkshire Hathaway never commits to holding a security, says Mr. Buffett. "It is true that we own stock that I have no intention of selling…But we have made no commitment that Berkshire will hold any of its marketable securities forever," he wrote in his letter. There are positions which have been held onto for years such as Wells Fargo WFC , American Express AXP , and Coca-Cola KO . However, for example, in 2016 Berkshire Hathaway bought large stakes in Apple AAPL and sold a majority of their stake in Wal-Mart WMT in an active charge to find yield.

Wall Street shows that investors are leaning towards low cost index funds over active managers who promise to beat the market. The Wall Street Journal writes that last year, investors pulled a net $342.4 billion out of active managers' hands and poured a record $505.6 billion into passively managed funds.

Mr. Buffett's advice: it is best for investors to use low cost index funds rather than handing their assets to active managers who charge high fees. "Both large and small investors should stick with low-cost index funds," he says.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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