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Did Buffett stack the deck?

Passive investing can be much more complicated than most assume

Dave Purdy
Dave Purdy is a portfolio manager at Acadian Asset Management, Boston.

In 2008, Warren Buffett made a bet that a passive portfolio could beat an active one over a 10-year period. Now he is declaring victory, and in the process is attracting a legion of followers to the passive cause.

But was the contest fair? And what, if anything, did it prove? Aside from the irony of one of the world's greatest active managers recommending a passive approach to investing, Mr. Buffett's contest helps illuminate why passive investing is far more complicated than many people assume.

First of all, what is “passive?” Linking back to modern portfolio theory and the capital asset pricing model, the platonic ideal of passive would be to hold all market securities in a cap-weighted portfolio. Since clearly this is not practical, investors long ago turned to proxies for the overall market, using groups of stocks that are supposedly representative of the market. This “active” approach to “passive” investing involves many decisions — including liquidity minimums and capitalization cutoffs, rebalancing schedules and turnover, factor exposures and risk — all of which require some degree of judgment. This inherently subjective element is, of course, inconsistent with a truly passive orthodoxy.

In constructing his wager, Mr. Buffett made many such judgments, and as a result he defined the terms of the bet in a way almost certain to influence the outcome.

To represent passive investing, he chose a limited U.S. market portfolio (the S&P 500 index), as opposed to something that would represent the true breadth of the equity universe, such as an all-cap global index. He set the trading and cash flow schedule to be one time (beginning of period), rather than using a dollar-cost-averaging approach (which is much closer to how people actually invest money). He also got to pick the measuring stick — total nominal returns, which make the results highly sensitive to start and end points, as well as interest rate regimes.

Moreover, his particular index was driven by very few stocks over the time period in question. Just three stocks make up 10% of the S&P 500 cap — Microsoft Corp., Apple Inc. and Google Inc. (now Alphabet Inc.) The top 10 stocks of the index contributed 80% of its return over this period. And the top 50% of cap is made up of only about 50 companies, which is a tiny fraction of the thousands of public companies listed in the U.S., hardly a proxy for the dynamic and ever-changing U.S. market!  (It's worth noting the S&P was once dominated by railroads and industrials. If the past is any guide, the leading companies of the future will not be the three listed above.)

But it was certainly a cagey play to pick the U.S. market as the passive bogey. It is the most efficiently priced equity market in the world, making it relatively hard to beat. Since we don't believe Mr. Buffett intended to suggest investors adhere to a home-country bias — a sure way to limit opportunity in a global world — we might assume he picked this benchmark for the challenges it presents to active managers. Given his expertise in active management, Mr. Buffett could have made no better choice.

It is also illuminating to consider Mr. Buffett's pick for a challenger — hedge funds. While presented in the bet as the epitome of active management, given the large degree of discretion they enjoy, hedge funds have very different goals from active equity managers benchmarked against an index. In the latter case, the manager is seeking to outperform a given benchmark at similar levels of market risk (beta). A hedge fund manager, in contrast, is seeking to outperform relative to cash. Comparing passive equity to hedge funds is not just apples to oranges, it is fruit compared to some other food entirely.

So why did Mr. Buffett not make the case for passive on a neutral playing field, with true active long equity duking it out against the index?

The answer is he would very likely have lost. Competing against a hedge fund focused on risk-adjusted absolute return offered a far less formidable opponent. In fact, hedge fund performance has suffered over the past 10 years in part due to adherence to one of Mr. Buffett's key investment tenets: don't lose money. The downside risk of the hedge funds used in the bet was far lower than that of the S&P 500. If we were to compare their returns to the S&P index on the basis of risk-adjusted return — Sharpe ratio — the gap would close dramatically. Moreover, if markets had gone down 30% instead of up 30% over this time period, the higher beta of the S&P investment would have resulted in a very different outcome.

Mr. Buffett is shrewd. He made a bet on a risky asset, the cap-weighted U.S. market, and compared it to a lower-risk mandate with limited market exposure. As history has shown, he is a formidable active investor. Unfortunately, this bet tells us nothing about the virtues of active vs. passive investing. Which makes it all the more puzzling he should be lauding passive investing in a shareholder letter.

Unless he is being very shrewd indeed. The success of Berkshire Hathaway Inc. underscores that a smart, disciplined investor can deliver consistent active returns. (Presumably Mr. Buffett is not recommending Berkshire shareholders sell their active stock and buy the passive index.) But in order to remain successful, it might well serve his purpose to promote passive investing, especially as the size of his active assets grows and his opportunity set becomes more limited.

Mr. Buffett is essentially arguing that the average investor lacks the ability to choose wisely in the active space. But it does not escape our notice that it is in his interest for investors to capitulate and come to the false conclusion that active investing is just too hard. Those who have jumped on the passive bandwagon at his behest have naively promoted this ideology, but perhaps without understanding the ultimate agenda. We, of course, can't know Mr. Buffett's true motivations. But the likely outcome of his passive advocacy is undeniable: as the field clears of active investors, opportunity will improve for those who remain.

To sum up: The crafty Sage of Omaha made a bet, and he made sure to structure the bet to suit his purposes. But in so doing he managed to neutralize the premise of his argument. His passive portfolio was an active choice, and his active bogey was mandate-constrained.

So how about a new bet, and this time, one that is fair? Let's level the playing field and see what happens when there is a truly viable contest between passive and active. We suggest the MSCI All Country World IMI index as a reasonable proxy for passive equity. For active, let's use a fully invested equity portfolio with a market beta target of 1.0, one that systematically seeks undervalued, high-quality stocks with strong earnings prospects in every investible country in the world. And let's look at net cumulative real returns (otherwise known as “what you eat”) as our measure of success at the end of 10 years. This is a bet our firm will take.

Mr. Buffett, we look forward to hearing from you.

This article originally appeared in the June 12, 2017 print issue as, "Did Buffett stack the deck?".