Warren Buffett's Love-Hate Relationship With Index Funds

Warren Buffett loves index funds. But for Berkshire Hathaway, he loves them not.

Jul 30, 2014 at 11:00AM

If my universe of business possibilities was limited, say, to private companies in Omaha, I would ... try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town.
-- Warren Buffett, 1991

Does Warren Buffett love index funds -- or hate them?

If the quote above provides any indication, he's not a fan of the concept. Buy shares in a broad range of unexamined businesses? That's not really this value investor's style.

Why, then, did Buffett do an about-face two decades later when he called index funds a "superior" alternative to managed funds? To find out, let's take a closer look at the Oracle of Omaha's thoughts on the matter.

Buffett Lecturing

Source: Flickr/Fortune Live Media.

Why Buffett finds indexing pointless (at times)
In his 1991 letter to shareholders of Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B), Buffett wrote skeptically about the idea of buying a market index rather than actively managing a portfolio. Here's a full recap of what he had to say:

If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town.

Buffett doesn't directly refer to indexing, to be sure, but he clearly reveals a lack of enthusiasm for the concept. Indexing implies ownership in a broad swath of businesses, many of which might not meet the investment criteria Buffett lays out above. If Buffett's made a fortune buying businesses that do meet those criteria, why would he adopt or advocate a different approach?

Buffett drives home his point by making an analogy to a universe limited to Omaha, Nebraska, his hometown. It's an attempt to connect the stock market -- which can sometimes seem like an abstract concept -- more directly to our day-to-day lives.

To extend Buffett's analogy, think for a moment of the neighborhood businesses that you love and patronize. Easy enough, right? Now think of the ones that you purposely avoid like the plague due to their poor service or inferior products. Holding an index fund containing the latter probably makes you cringe. Logically, then, it makes little sense for an investment manager either. And yet that's exactly what passive indexing requires.

By 1991, Buffett was actively disproving the efficient market theorists who believed that no individual investor could be smarter than the market itself. With Berkshire's compounded annual book value growing at 23%, Buffett and his investing partner Charlie Munger were defying all odds.

With that information in mind, his skepticism of index funds seems warranted. If Buffett bought into each and every stock in the S&P 500, there would be no reason to believe that Berkshire would ever beat the market. Passive indexing, by definition, cannot yield superior results.

Instead, Buffett reiterated to shareholders that he would continue to identify companies with superior "long-term economics" while paying particular attention to the "quality of the people in charge of running" those companies. Using that formula, he uncovered some incredible businesses, including companies like Coca-Cola, Procter & Gamble, and Wells Fargo, along the way. That was Buffett's job, plain and simple.

Get the picture? Now let's turn it on its head.

But also sings its praises
While Buffett put little faith in indexing in 1991, 23 years later his advice seems lost on investors. The amount of money put into index funds has ballooned since then. In the last decade alone, the percent of U.S. equity assets indexed jumped from 17% to 35%, reaching a sum of $2.3 trillion in total.

That's astounding. But what might seem more astounding is that Buffett wholeheartedly endorsed indexing in his 2013 shareholder letter. He outlined how his survivors should handle his estate, and here's what he had to say:

My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions or individuals -- who employ high-fee managers.

Really? A low-cost S&P 500 index fund? Juxtaposed with his earlier statement, this makes it seem as if Buffett had flip-flopped and hopped on the indexing bandwagon. But here's where context plays an important role in interpreting these two Buffettisms.

What it boils down to is that Buffett has full faith in his investing ability, but he can't speak for the stock-picking ability and temperament of others. Investing is Buffett's full-time career, and he's honed his craft over the years. As studies have shown, he's a step ahead of the rest of us.

Most important, Buffett's seen too many professional money or fund managers nickel-and-dime their clients while generating inferior returns. These same "advisors" can often amplify their clients' tendencies to trade too often and at the wrong times. Faced with that alternative, Buffett's written glowingly about index funds in recent years. He pointed out these types of pitfalls in his 2013 letter:

Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

So, in a nutshell, average investors like us face some significant hurdles, including inferior stock-picking skills relative to Buffett, a tendency to take unnecessary actions, and a money manager who's probably tempting us to pull the trigger on costly trades. That's not a recipe for success. That's a laundry list of reasons to dive into a low-cost fund.

Do as Buffett says, not as he does
Buffett's comments over the years could be construed to reflect an ever-changing love-hate relationship with the index fund, but that would miss the point. His time-tested stock-picking approach beat the market, so he stuck with it. He recognized that for nonprofessional investors, however, passive investing would -- on average -- produce higher returns, primarily due to the elimination of fees.

Investors like you and I, quite frankly, are sitting in a different boat than Buffett. That doesn't mean we can't invest in stocks on our own account, it just means we should honestly reflect on our abilities. And stay away from costly advisors and fee-laden funds.

For some of us, it might be a perfectly good idea to do as Buffett says and not as he does: Avoid money managers, find a cheap index fund, and get on with our lives.

Isaac Pino, CPA, has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway, Coca-Cola, Procter & Gamble, and Wells Fargo. The Motley Fool owns shares of Berkshire Hathaway and Wells Fargo and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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