For many years, Warren Buffett has advised his followers that index funds are a preferred investment option for many individuals who may not have the background or desire to actively manage a portfolio. He once told Jack Bogle:
A low-cost index fund is the most sensible equity investment for the great majority of investors. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.
On two occasions, Buffett even acted upon his own advice. Beginning in 2008 he bet Ted Seides of Protégé Partners that over a ten year period an S&P 500 index fund would outperform against an aggregate of five funds of hedge funds selected by Mr. Seides, with the proceeds going to a charity selected by the winning individual. In the end, Buffett won as the five funds of funds averaged a gain of between 0.3% and 6.5% versus an 8.5% gain for the S&P 500 index fund.
The second occasion was somewhat more personal. The funds Buffett has set aside for his wife in a trust have been directed to be invested 90% in an S&P 500 index fund, with the other 10% invested in short-term government bonds. He wrote in the 2013 annual report:
My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) 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.
The rationale for owning index funds is pretty straightforward. The various money managers paid to invest funds actively, whether in mutual funds, hedge funds, or other vehicles, largely comprise “the market” and so the average active investor is likely to lag the market after fees have been accounted for. According to Morningstar (MORN) only 23% of active funds beat a passive index in the ten years ending in June 2019.
Retail investors are also, on average, better off investing over time in index funds rather than buying and selling individual stocks since the average retail investor is simply not equipped to manage a portfolio. Emotions too easily take hold and individual stocks are bought high and sold low. According to Dalbar’s Quantitative Analysis of Investor Behavior study, published in 2017, the average retail investor earned 4.79% investing in stocks over a twenty year period compared to a return of 7.68% from the S&P 500. True, an investment in an index fund does not completely eliminate the emotional factors involved in when to invest, it does eliminate the what to invest in problem and makes it far easier for investors to act rationally and average into a fund over a period of time.
These facts, of course, beg an interesting question. If a passive strategy is generally superior to an active one, why has Buffett’s investing vehicle Berkshire Hathaway not followed the same advice? Buffett was asked at the 2019 Berkshire Hathaway (BRK.A) (BRK.B) shareholders meeting why he has not taken some or all of Berkshire’s excess cash and invested it in an index fund. You can view his full response in the video below.
The salient part of Buffett’s response centered on Berkshire’s ability to act as a counter-cyclical investor, with tens of billions of dollars in liquidity when a set of opportunities arises. That special aspect of Berkshire’s structure would be eroded if large amounts of Berkshire’s excess cash were invested in an index fund.
That is an alternative that, for example, my successor may wish to employ, because on balance I would rather own an index fund than carry treasury bills. I would say that if we had instituted that policy in 2007 or 2008 we would have wound up in a different position in terms of our ability to move, late in 2008 or 2009…there are conditions under which we could spend $100 billion very, very quickly and if we did, if those conditions existed, it would be capital well deployed and much better than an index fund.
This question of Berkshire Hathaway’s excess cash, and what to do about it, stands at the center over debate on the stock itself. At the end of September 2019, Berkshire reported $124 billion in cash and treasury bills and a further $19 billion in fixed income securities, indicating that the company easily has $100 billion in dry powder. Without an attempt to caricature viewpoints, bulls on the stock point out that they believe the cash will be put to excellent use as opportunities arise and/or the stock market corrects. Meanwhile, bears point out that Berkshire’s size is beginning to limit the use of that cash and Berkshire is unlikely to see the opportunities it once did.
Given that debate, and Buffett’s historical viewpoints on index funds, it was extremely interesting to see that in the latest 13F filed by the company, it had purchased two S&P 500 index funds, investing $12.7 million in each of the Vanguard 500 (VOO) and SPDR S&P 500 (SPY) ETF’s.
Some of the suspense of these purchases has already been resolved with Buffett’s assistant telling Bloomberg that the purchases were made for Berkshire’s pension funds. Since that is the case, we can say with near certainty that Todd Combs or Ted Weschler made the purchases since they are managing a large portion of Berkshire’s pension portfolio.
As of the end of last year, Berkshire’s consolidated pension portfolio totaled nearly $15 billion, with the allocation shown below.
Berkshire Hathaway’s consolidated pension fund assets by investment type, gross amounts in millions of U.S. dollars and percentage allocations, at year-end 2018. Source: Company filings.
Interestingly, Berkshire in aggregate has already allocated almost a quarter of its pension portfolio to “Investment Funds and Other.” No more detail is provided in Berkshire’s financial filings on these investments. However, some clarity is gained from reviewing the annual report of Berkshire subsidiary Berkshire Hathaway Energy – which does not appear to be managed by Mr. Combs or Mr. Weschler (my guess as to the reason is regulatory restrictions on how some pensions can be administered) – shows more than $2 billion in investments in investment funds and L.P. interests with a bit more detail behind them.
Berkshire Hathaway Energy’s consolidated pension fund assets by investment type, gross amounts in millions of U.S. dollars, at year-end 2018. Source: Company filings.
Berkshire Hathaway Energy’s pension summary comes with the following notes:
Investment funds are comprised of mutual funds and collective trust funds. These funds consist of equity and debt securities of approximately 59% and 41%, respectively, for 2018 and 62% and 38%, respectively, for 2017. Additionally, these funds are invested in United States and international securities of approximately 73% and 27%, respectively, for 2018 and 68% and 32%, respectively, for 2017.
Limited partnership interests include several funds that invest primarily in real estate, buyout, growth equity and venture capital.
In the context of the pension funds at Berkshire Hathaway, a purchase of a pair of index funds does not present any large shift in strategy, since it is clear that at least some subsidiary pension funds were already investing in various mutual funds and limited partnerships. Further, the roughly $25 million that were invested in the two index funds comprises about 0.17% of Berkshire’s total pension investments.
So, why did either Mr. Combs or Mr. Weschler decide to make this investment? No one but them can say for sure, but it is likely a simple case of an asset allocation decision. In the context of a single plan being managed by one or both of the two men, $25 million may have been more meaningful and left the pension fund at a place where the manager was comfortable with the equity allocation, even if no specific equities were on their radar for purchase.
What, then, does the purchase signal for Berkshire Hathaway’s future? Perhaps nothing at all. Although it is worth pointing out again Mr. Buffett’s own words quoted before, “That [investing in an S&P 500 index fund] is an alternative that, for example, my successor may wish to employ.” It would not be terribly surprising if, given the mountains of cash that Berkshire generates and needs to reinvest, that investments like this were more likely to be chosen in the future. That could be true whether the investments are made within the investment portfolio of the insurance subsidiaries or in managing the pension portfolio.
Given that the investment was not made by Mr. Buffett, though, investors should read very little into the move as a signal to what Berkshire will be doing in the short-term. The cash is likely to continue piling up. To use another of Mr. Buffett’s analogy, rather than using index funds, he will continue ‘waiting on his pitch.’
Disclosure: I am/we are long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.