Warren Buffett's Egregious Hypocrisy On Index Funds

Warren Buffett should let his employees put their money where his mouth is.

For years, the Oracle of Omaha has passionately argued the virtue of low-cost index funds. In his 2016 letter to shareholders, he proclaimed that “investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.” Moreover, he has specifically focused on passive investing as a mechanism for people to boost long-term retirement savings, recommending that investors “consistently buy an S&P 500 low-cost index fund [because] I think it's the thing that makes the most sense practically all of the time.”

And yet, as a recent ProPublica investigation discovered, many of the subsidiary companies of Buffet’s conglomerate, Berkshire Hathaway, do not offer low-cost index funds as options in workers’ retirement accounts. Allan Sloan, the lead author of the ProPublica report, succinctly captured the palpable irony: “The most successful investor of our age, who advises average investors to buy low-cost index funds. . . presides over a company where many employees don’t have a chance to invest as he suggests.”

The merits of investing in index funds have been well established, but are worth summarizing. Index funds are intended to mirror the basket of stocks in – and match the performance of – a stock market benchmark, such as the S&P 500. Unlike active funds that are overseen by fund managers who make frequent trade, index funds are passively managed and hold investments for longer periods of time. This means that most have lower management and transaction costs than actively managed funds. As Buffett himself argues, "costs really matter in investments. If returns are going to be seven or eight percent and you're paying one percent for fees that makes an enormous difference in how much money you're going to have in retirement."

The index fund movement has started to proliferate throughout the U.S. For example, Vanguard, the longtime champion of index funds, took in over $800 billion dollars between 2015 and 2017 compared to the less than $100 billion the rest of the mutual fund industry took in during the same period. Research has shown that most investors are better off with index funds because of the high costs associated with active management and because the majority of actively managed funds fail to outperform their respective indexes.

For example, the S&P Dow Jones Indices company has published a yearly scorecard, SPIVA, measuring the performance of actively managed funds vis-à-vis their respective stock market benchmarks. The most recent report for 2017 showed quantitative evidence that “the majority of active equity funds underperformed over the longer-term investment horizons.”  As the table below shows, the S&P 500 index performed better than 86.72% of All Domestic Funds and 91.17% of All Small-Cap Funds over a 10 year horizon.  More generally, over short, medium, and long-term time horizons, managers of active funds ranging from small-cap to large-cap, lagged behind respective benchmarks most of the time.

 Over short, medium, and long-term time horizons, managers of active funds ranging from small-cap to large-cap, lagged behind respective benchmarks most of the time.

Over short, medium, and long-term time horizons, managers of active funds ranging from small-cap to large-cap, lagged behind respective benchmarks most of the time.

As Russell Kinnel, Morningstar's director of mutual fund research, sums up, “If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. Expense ratios are strong predictors of performance. In every asset class over every time period.” In other words, index funds are hands-down your best investment bet in the long run.

Buffett is such a huge believer in index funds that in 2007 he wagered $1 million that the Vanguard S&P 500 index fund would outperform a portfolio of actively managed hedge funds over 10 years when all fees and expenses were included. The bet ended in 2017 with Buffet’s index fund trouncing a portfolio of funds selected by Protégé Partners. Buffett’s fund averaged an annual gain of 8.49%, while Protégé’s five funds (A - E) averaged an annual gain of a meager 3%. In other words, after 10 years, a $10,000 investment following Buffett’s strategy would leave you with over $22,500, while the same investment following Protégé Partners’ strategy would leave you with only $13,600 or almost $9,000 less.

 Total Returns for Buffett/Protege Partners Bet based on data in 2017 Berkshire Hathaway Annual Letter

Total Returns for Buffett/Protege Partners Bet based on data in 2017 Berkshire Hathaway Annual Letter

Given Buffett’s index fund gospel, you’d expect the retirement plans at companies within the Berkshire Hathaway family to feature myriad low-cost index funds and a dearth of high cost, actively managed funds.

But ProPublica’s investigation unearthed the exact opposite.

An examination of the investment plan options offered to workers to save for retirement at 50 of the 63 Berkshire subsidiaries, found that “many offer little or nothing in the way of index funds.” Instead, the report found that the available plans vary considerably across the companies and consist of high-cost funds that provide less-than-stellar growth for workers’ hard-earned retirement money.

For example, while Berkshire-owned BoatUS employees have access to S&P 500 index funds, the fees they pay are fifteen times higher than those paid by employees at other Berkshire-owned companies such as NetJets, GEICO, and Clayton Homes. More egregiously, Buffett-owned Borsheim’s Fine Jewelry “offered employees 71 investment options, virtually all of which (other than 10 Vanguard target date retirement funds) consisted of actively managed funds.”

 High fund fees eat away at your hard-earned money costing thousands over time (Photo Credit:  DepositPhotos)

High fund fees eat away at your hard-earned money costing thousands over time (Photo Credit:  DepositPhotos)

You’d think someone as financially savvy as Warren Buffett would leverage the collective power of all Berkshire companies to receive better fund options and pricing.  However, instead of taking this approach and looking for opportunities to pass the savings to his employees, Buffett appears to leave each company to negotiate its own plan. While this fits with his laissez-faire style, the implications for his employees are severe and negative, potentially costing them thousands of dollars in retirement savings.

In his 2017 letter to shareholders, Buffett mused that “over the years, I've often been asked for investment advice. . . my regular recommendation has been a low-cost S&P 500 index fund.”

Indeed, the passively managed Vanguard 500 Index Fund that Buffett used to crush Protégé Partners has a minuscule expense ratio. It’s a shame many of the employees at his subsidiaries can’t heed his sage advice and invest in it.

(This article first appeared in Forbes on April 11, 2017)