Incredulously, on May 5th 1997, I found myself standing in line at 6:00 a.m. with hundreds of other folks. On this beautiful spring morning, we were waiting to file into the Aksarben Coliseum just outside Omaha, Nebraska. The doors would not open for another hour, and the meeting would not start until 9:30. When the meeting began, the place was packed with about 9,000 attendees. A typical corporate annual meeting attracts a few hundred, perhaps a thousand, investors. But this was no typical annual meeting. I was the “capitalists’ Woodstock”, the annual meeting of Warren Buffett’s Berkshire Hathaway. And the venue was a hockey rink! When the greatest investor in the history of civilization entered the building, a thunderous applause broke out.
Buffett took his customary place next to Berkshire Hathaway’s Vice Chairman, Charlie Munger, and the formalities of the annual meeting took the customary ten minutes. Meeting over. At this point the real reason for the gathering began: The Q&A session. You see, the question and answer session of a Berkshire Hathaway annual meeting is when investors—many of them richly rewarded for holding their Berkshire shares—get to ask the ultimate investing expert any question imaginable. And Buffett aims to please, since the Q&A sessions usually run four to six hours. A dozen or so microphones were scattered around the coliseum, and the faithful lined up for the greatest teaching thrill of their investment lives. This year, one of the first came from a woman who wanted Buffett’s thinking regarding high investment fees relative to performance in the mutual fund space. Buffett prefaced his reply by saying, “The typical mutual fund manager—even the good ones—have a difficult time beating the S&P 500 over the long run. They might wish to consider passive investing through an index fund.” Jaws dropped, heads turned. Many in attendance that day were, in fact, investment managers. Berkshire, at that time, also held a very large position in Salomon Bros. common stock (one of the premier investment banks at the time). Salomon had a very large money management division. Here was the world’s greatest active manager (active managers try to pick stocks that will outperform a benchmark), a man with a 35-year track record that had smashed the S&P 500 to bits, and he was advocating the merits of passive investing (passive investors simply buy the whole index such as the S&P500 using a mutual fund, ETF, or if large enough—like a pension fund—buy each stock in the index in its exact proportion). The irony exploded across Aksarben. Class was in session.
As Buffett was amassing one of the great track records of all time, John Bogle was quietly amassing an extraordinary track record of different kind, a thousand miles away in Valley Forge, Pennsylvania. The Vanguard Group’s flagship fund, the Vanguard Index Trust (now named the Vanguard 500 fund) which tracks the S&P 500 Composite Index, was slowly but inexorably fulfilling the Oracle of Omaha’s prediction. Over the next 25 years, the S&P 500 and the Vanguard Index Trust beat most investment managers. The market, as some contend, is efficient. You can’t outguess the sum total of all the knowledge that goes into the market. The thinking with passive investing is, “if you can’t beat it… you might as well join it.” And that is why trillions of dollars are passively invested around the globe. You will never make ten times your money in indexing in a few years like you could in a hot biotech stock. To be sure, there are inefficient markets where active managers have some sort of edge. Some international markets and emerging markets, as well as certain sectors, have some inefficiencies that can be exploited. And as mentioned, if you can get into early cutting-edge healthcare or biotechnology, then you can score some rather large gains that would trample the indexes.
Why is it such a challenge to beat the indexes? Three primary reasons.
- The S&P 500 and other benchmarks of performance don’t pay fees. It is an unmanaged index of stocks. If, however, you want to invest in these stocks, you will pay fees; management fees and transaction costs all add up and cause a headwind for investors.
- The unmanaged index pays no taxes. It’s a number. An economic indicator. If an investor sells stocks, it’s a taxable event in the United States and the IRS is one entity that always gets its take.
- Cash drag. Most money managers are not fully invested. They always hold some cash. If the market advances 5% in a given month, and they are holding a good amount of cash, they will underperform. It’s that simple.
Add these three headwinds up, and it makes it hard to beat the benchmarks. But it can be done. I repeat; it can be done. There are two ways. One is to minimize all three of the reasons above. Buy a nice diverse basket of stocks and hold for the long run. This way you minimize transaction costs, taxes and cash drag if you are fully invested. We spoke on this website months ago about coffee can investing and the Voya Corporate Leaders Trust mutual fund. It bought a basket of stocks some 80 years ago… and held. The trust only sold if a company went bankrupt or was merged into another company. No taxes. No transaction fees. Mostly fully invested. NO CASH DRAG. The result: it beat the index hands down. The Sequoia Fund (until the recent Valeant debacle) was another fund that minimized taxes and fees and also had a stellar long-term record.
Is there another option instead of choosing between passive and active—does one have to do one or the other? The answer my friends, is do both. The two strategies actually coexist pretty well. There is even a fancy name for the term—it’s called core-satellite strategy. You have an investment “core” consisting of a passively managed investment or index fund. The strategy is surrounded by “satellites” of active investing or stock picking (See diagram below).
It’s a strategy practiced by many pension funds and asset managers throughout the institutional world. Financial advisors over the years have come to believe that it’s not always an ill-fated love affair to combine both passive and active strategies. In fact, many investors have core satellite portfolios and they don’t even know it. Anyone with money in an index fund and a couple of regular passive mutual funds in an IRA or 401k is a closet core satellite investor (I count myself as one of them).
Moreover, at the end of every issue of In Sickness and Wealth, is the Personal Portfolio. And, even though it’s a portfolio focused on health care, at its very heart is the core satellite strategy. There is a core healthcare index allocation accomplished using the Healthcare Sector SPDRs (XLV—is an ETF which owns 57 healthcare stocks that make up the healthcare sector of the S&P 500). It is surrounded by satellites of stock picks that we have made over the last several decades. The healthcare portfolio was built one stock at a time, since the early 1990s. It started with a $1,000 invested in Johnson and Johnson and is now comfortably in six figures.
The active and passive camps can coexist. And in the July or August issue of In Sickness and Wealth, we will review the personal portfolio and how it was constructed… one brick at a time, both the passive and active components. It is well constructed and has withstood several bear markets, 9/11, the Bushes, the Clintons, and Obama; I expect it will survive either Hillary or Trump as well.