By Druce Vertes, CFA Image credit: ©iStockphoto.com/animatedfunk Warren Buffett sometimes says things that seem… contradictory. For example, in the “You don’t have to be a genius to be a great investor” category: ” Success in investing doesn’t correlate with IQ once you’re above the level of 25.” “If you are in the investment business and have an IQ of 150, sell 30 points to someone else.” He loves tweaking academic proponents of the efficient market hypothesis (EMH): “I’d be a bum on the street with a tin cup if the markets were always efficient.” ” Naturally the disservice done students and gullible investment professionals who have swallowed EMH has been an extraordinary service to us . . . In any sort of a contest – financial, mental, or physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.” And yet Buffett also says most people should steer clear of active investing: Like those same gullible investment professionals and misguided EMH proponents, he recommends low-cost index funds. “A low-cost index fund is the most sensible equity investment for the great majority of investors.” “My advice to [his own self-selected!] 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.” How can Buffett say passive investing is best for most people and also an “enormous advantage” for active investors like him? If it helps everyone else, how can it also help him? The opposite view is sometimes described as the ” suckers at the poker table ” hypothesis – the theory that an increase in passive investing is bad for active investors like Buffett because the fewer suckers there are to fleece, the less profit there is for smart active investors. So which view is right? The “suckers at the poker table” theory, or Warren Buffett, who says passive investors make his job easier? And how can Buffett be right while at the same time saying most people should invest passively? Let’s do a simple thought experiment: What would happen if everyone was a passive investor except Warren Buffett? As is often the case, we find that Buffett is way ahead of everyone else. He is both correct and self-serving. Anyone can use an index to match the market on a holding period-return basis, and yet Buffett can still crush everyone else on a money-weighted basis. A brief theoretical digression: The Grossman-Stiglitz paradox holds that you can’t have a perfectly efficient market because that requires someone to be willing to arbitrage away any inefficient price. But arbitrageurs have to get paid. So they will only step in if they’re compensated for their time, data services, research, compliance, office rent, overhead, and an adequate after-tax, risk-adjusted return. So markets tend towards an equilibrium where prices are boundedly efficient, where there is no more mispricing than at the level that would make arbitrage profitable. The set of all investors is the market itself and, in the aggregate in any given period, earns the market return. The subset of index investors, by virtue of owning the market portfolio, also earns the market return. To make the indexers and non-indexers add up to the market, the non-index investors in the aggregate must also earn the market return. 1 In the aggregate, those “arbitrageur” active investors aren’t making any excess profits! Before expenses, they are matching the market, and after expenses they are underperforming. In order to have any profitable active investors, it seems you have to posit overconfident, “dumb” active money that loses money trading against the “smart” arbitrageurs. And that doesn’t make much sense. It implies the persistence of a class of irrational investors. If there’s a tug of war between smart money and dumb money, and a priori the dumb money is as strong as the smart money, and it’s to the smart money’s advantage to trick the dumb money whenever possible, why should that make prices efficient? It sounds like a theory of irrational traders and not very efficient markets. Let’s see if another thought experiment can shed some light: What happens if passive investors take over the market so there is only one active investor left: our hypothetical Warren Buffett? Let’s disregard for the moment changes in the composition of the index. We only have Buffett trading with passive investors. The passive investors just want to enter and exit the whole market. They don’t want to trade individual stocks or a non-market-weighted portfolio. And there are no other active investors to trade with other than Buffett, who makes a bid-ask market for the index, selling when it’s above his estimate of fair value and buying when it’s below fair value. A somewhat trivial example, which should be familiar to those who have done the CFA curriculum on holding period vs. money-weighted returns: Cash Flows Index Fair Value Index Price Premium/ Discount Holding Period Return Cost Averaging Investor 1 Dumb Investor 2 Dumb Investor 3 Warren Buffett Corporate Issuance Year 0 $ 100.00 100.00 0% (1,000) (1,000) (1,000) – 3,000 Year 1 $ 105.00 94.50 -10% -5.5% (1,000) – 945 (1,000) 1,055 Year 2 $ 110.25 121.28 10% 28.3% (1,000) (1,000) (1,000) 1,283 1,717 Final value $ 115.76 115.76 0% -4.5% 3,337 2,112 955 – Holding period return 5.0% 5.0% 5.0% 5.0% Money weighted return (IRR) 5.4% 2.7% -5.0% 28.3% The index fair value grows at 5% per year. It starts priced at fair value in Year 0, in Year 1, it trades at a 10% discount, in Year 2, at a 10% premium, and then finally returns to fair value in Year 3. The holding period return, which ignores flows, is 5%, matching the index. Dollar cost averaging Investor 1 buys $1,000 worth of stock each year and has a money-weighted return of 5.4% as a result of automatically buying more shares when they are cheap and fewer when they are expensive. Dumb Investor 2 panics when the market goes to a 10% discount and doesn’t buy that year and ends up with a 2.7% money-weighted return. Dumb Investor 3 panics even worse, sells when the market goes to a 10% discount, and ends up with a -5.0% money-weighted return. Warren Buffett stays out of the market until it trades at a 10% discount, sells at a 10% premium, and ends up with a 28.3% money-weighted return. Everyone gets the same 5% holding period return, which ignores flows. But on a money-weighted, risk-adjusted basis, of course, the returns are very different, and our Warren Buffett crushes the market. One way of looking at it is Buffett increases the size of the overall pie when the odds are in his favor, shrinks it when they aren’t, and outperforms without necessarily taking anything from the other investors, who earn the market return in each holding period. Another way of looking at it is to consider the whole scenario as one holding period during which Buffett took advantage of people who were selling low and buying high. Effectively, our Warren Buffett sets a floor under the market when events or cash flows make the passive investor inclined to sell excessively cheap and sets a ceiling when the market gets expensive. If you examine any individual year, everyone here is a passive investor in the sense of always holding the index. But if you think of the entire scenario as one holding period, only someone who owns the index and never trades is really a passive investor. Everyone else is buying high or selling low within the period. If you’re planning to invest for an objective other than buying and holding forever, you have to make decisions about when and how much to invest and when and how much to withdraw. On a sufficiently long timeline, the probability of being a completely passive investor goes to zero. Eventually, you have to make an active investment decision, and at that point, the shrewd investors are lying in wait. Everyone eventually has to pay Charon to cross the river Styx. It gets even better for Buffett when you incorporate index changes. An IPO comes out. The IPO is initially not in the index. Our hypothetical Warren Buffett sets the IPO price. He doesn’t have anyone to bid against or anyone to trade with besides the issuers since the stock is not yet in the index. Being an accommodating fellow, he sets the price at fair value minus his margin of safety, illiquidity discount, etc. The IPO eventually gets added to the index. Indexers have to buy the stock. Buffett solely determines the price at which it gets added to the index. In his obliging manner, he sets it at fair value for a liquid index stock plus a reasonable convenience premium. What a sweet deal! Pay a steep discount for any security not in the index and demand a big premium when they go into the index. Similar profits are available when securities exit the index. Going back to the Grossman-Stiglitz paradox, the arbitrageur active traders can do pretty well, even without the existence of a large pool of permanently underperforming “dumb money,” which is unnecessary and illogical. They pull a bit of Star Trek’s Kobayashi Maru scenario by going outside the bounds of picking stocks from within the index. The “suckers at the poker table” paradigm goes astray because there isn’t some exogenous fixed size of the investment pie investors are fighting over. The returns are endogenous: They are in part determined by how smart the investors are, how well the capital in the economy is allocated, and by everything else that impacts economic and market outcomes. The size of the profits pie is not fixed. When investors take a risk funding an early Apple (NASDAQ: AAPL ) or Wynn (NASDAQ: WYNN ), they increase the size of the overall pie, getting a bigger slice without taking a commensurate amount from everyone else. Smart money going into appropriately priced investment opportunities grows the whole pie. Dumb money going to bad businesses shrinks the pie. Once it’s not a strictly zero-sum game, you don’t need “suckers at the poker table” to outperform. Sufficiently smart money creates its own suckers. Bill Ackman, in his most recent Pershing Square letter, asked “Is There an Index Fund Bubble?” He pointed out that if index funds generally side with management, they make the activist’s job harder. But increased herding can be a self-fulfilling prophecy with bubble dynamics, and it increases opportunities outside liquid indexes. There are useful parallels between investing and poker , but investing is not a zero-sum game, dumb money is not the primary driver of returns for most strategies, and the “suckers at the poker table” is not a useful analogy for most long-term investors. 1 This accounting excludes issuers of stock, who are kind of important. Companies are net distributors of cash to their stockholders. They pay dividends and they on net buy back stock , these days. So everyone cannot be a passive investor in the S&P and reinvest dividends. If they tried, something would have to give. Investors would bid up stocks until someone capitulated and started selling, or companies started issuing stock, or something. When it’s not a zero-sum game, reasoning from accounting identities tends to be misleading. 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