Why I’m betting against Warren Buffett on this one

When Warren Buffett thinks you should park your money in low-cost passive funds, it’s time to pay attention. But could the Oracle of Omaha be suggesting people go passive at the wrong time?    

While I know it’s a big call to bet against the advice of a man who’s essentially written the book on long term investing, I’d actually be surprised if active managers don’t outperform passive funds in the period ahead. 

Let me be clear: not ALL active managers will outperform the broader share market indices and passive funds, but the time is right for high quality active managers to shine.

I have been evaluating the skills of active funds managers for many years and my experience is that most high quality active managers share a common trait – a strong belief about the type of companies and stocks that can outperform and a singular focus on finding these gems. They simply aren’t trying to pick every market turn.

While I am confident that the best of these managers will out-perform over time, experience shows they can be out-of-synch with market conditions for uncomfortably long periods. Understanding the fickle nature of markets can help you decide whether spending money on active management is the right decision for you.

Warren Buffett himself, the world’s most famous value investor, has outperformed the market over a very long time. Yet, even he has had protracted periods of lower than market returns.

Fortune reversal 

Looking at the statistics it’s easy to see why Buffett would make such a stark observation. In the US, about 90 percent of active fund managers under-performed their index targets over trailing one, five and ten-year timeframes, according to a 2016 study by S&P Dow Jones Indices.

The reason I believe this trend is likely to change is the noticeable shift in markets conditions that began last year. That’s happening because governments are starting to wind back interventions made during and after the global financial crisis.

Many countries undertook significant quantitative easing during the financial crisis to provide liquidity and expand their balance sheets. This coupled with ultra-low – and sometimes even negative – interest rates, dampened volatility. 

One of the side-effects of low interest rates is that they have given a leg up to poorer companies.

Indeed, what we’ve seen happening here is the gap between good and bad companies narrowed due to the government’s interventions. We have come through a period where the advantages of being in a better company haven’t shown up because of these macro factors.

Now that the US Federal Reserve has begun to tighten (article here) and Europe is likely to slow its asset buying next year, these differences in quality will become more evident and active investors will be the ones who benefit. You can already observe the change within markets through the widening dispersion in stock performance.

We are beginning to see the performance of active managers coming to the fore with some very impressive results from our global value and our quality growth managers over the past year. 

I’m not the only one who is noticing the improved conditions for active management.

Peak passive?

According to Morningstar, passive funds in the US attracted cash at 1.4 times active funds in the six months to June 2017, down from 5.1 times for the previous period.

Ultimately, I reckon the choice between an active approach and a passive one is best made strategically.  To my mind, it comes down to two things:

First, you need to find the right active fund manager - a skilful team who actually put in the hard work.

Second, you need to have the stomach for it. You need to be able to ride out the highs and lows and not give up when your strategy is temporarily under-performing.

If this is not you, then perhaps passive investing might be a better option.

For my money, I favour a passive manager in combination with a small group of highly skilled active managers. The diversification across active managers helps address the temptation to give up at the wrong time. 

Warren Buffett’s advice to avoid excessive fees shouldn’t be ignored. While I can see a tail wind for active managers in the period ahead, the choice of an active approach isn’t right for everyone. 

However, while he advises American savers to consistently buy S&P500 index funds, investors should consider the benefits of greater diversification across sector and geography.  

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