Why Buffett bats for index funds

Thousands of investors from around the world tune into the annual general meetings of American conglomerate Berkshire Hathaway Inc. and read its shareholder letters.

They hope to receive investing wisdom from Warren Buffett, Berkshire’s Chairman and CEO, who has become one of the world’s richest men by owning shares in great American companies.

But one piece of advice that Mr. Buffett repeats in every meeting, whenever asked for stock tips, is to invest in an index fund instead. “Consistently buy an S&P 500 low-cost index fund. Keep buying it through thick and thin, especially through thin,” he once quipped. Mr. Buffett has also said that after his death, he’s instructed his trustees to put 90% of his estate into an S&P 500 index fund for the benefit of his wife. This may seem to be strange advice, coming from a veteran investor who has amassed more than $100 billion by actively buying and owning equity stakes in American companies. But Mr. Buffett has sound reasons to recommend index investing to folks who aren’t professional investors.

Whether you’re an Indian investor who’s new to the stock market or a person at the middle of her career who doesn’t have the time to pick stocks or funds, Mr. Buffett’s advice can apply to you. If you’re keen to participate in the return potential of equities without having to manage your portfolio, you can simply take the passive route. Passive investing entails buying into an index fund or Exchange Traded Fund (ETF) that mirrors a broad market index such as the Sensex 30, Nifty50, Nifty100 or Nifty500, by owning the same basket of stocks that the index holds.

Own the biggest

For an investor looking to own equities, one of the toughest choices to make is selecting the right stocks or equity funds to buy. Social media, Whatsapp and Telegram channels are choc-a-bloc with stories of how an investment in Infosys or Asian Paints shares 20 years ago would have made you rich beyond your wildest dreams today. But such stories are shaped by hindsight. For every stock that delivers double-digit gains over the long run, there are dozens that don’t get even to a savings-bank return.

In 2021 at a Berkshire meeting, Mr. Buffett explained that there’s a lot more to picking stocks than figuring out what’s going to be a ‘wonderful industry’ in future. “There were at least 2,000 companies that entered the (U.S.) auto business (in the 1900s) because it clearly had this incredible future, but in 2009, there were three left, two of which went bankrupt.”

Investors who’ve been around in Indian markets since the nineties will have similar stories to relate about textile giants such as Century Textiles and Bombay Dyeing which used to be part of the Sensex but now are a shadow of their former selves.

If you invest in actively managed mutual funds instead of index stocks, a professional manager does the stock picking for you. But you will still need to choose between hundreds of actively managed equity funds that are sliced and diced based on their market cap, style, sector and themes.

An index fund helps you own a basket of the largest and most actively-traded stocks in the economy, by market value. Market indices such as the Nifty50, Nifty100 or Sensex 30 act as a barometer of the economy and the market. They are, therefore, designed to own the largest and most active stocks in the market, from the listed universe of 5,000-odd stocks, at any given point in time. Companies or sectors that don’t perform well or fall off the radar, over time, are automatically replaced by new ones that are growing faster. An investment in a Sensex 30, Nifty 50 or Nifty 100 index fund is simply a bet on the largest companies in the Indian economy.

Low costs

Globally, hedge fund managers are considered to be the smartest folks in finance, juggling among stocks, bonds, exotic instruments and derivatives across countries with the aim of delivering absolute returns, across market conditions. In 2007, Mr. Buffett issued a challenge to the U.S. hedge fund industry saying that it couldn’t outperform a simple S&P 500 index fund over the next 10 years, after fees.

The point Mr. Buffett was trying to make was about the difference that fees can make to an investor’s long-term results. Hedge funds have traditionally charged quite a stiff fee for their skills consisting of 2% of annual assets in addition to a share of gains above a hurdle rate.

Protégé Partners, an advisory firm, accepted the challenge to create a portfolio of hedge funds. But nine years on, in 2017, it was forced to throw in the towel on the Buffett challenge. In the nine years to 2016, the S&P 500 index fund was up about 85% while the selected hedge funds managed just a 22% gain. When you invest in actively managed equity funds, Portfolio Management Schemes (PMS) or curated portfolios like smallcases, you pay a fee to the portfolio manager to choose the best bets for your portfolio.

The management fees can take a significant bite out of your returns in the long run. Moreover, if the fund or portfolio you own underperforms the market, you may need to sell it and switch to a better performing alternative. This entails capital gains tax and brokerage.

Passive investing saves you both kinds of costs. One, because they merely copy an index and don’t attempt any active stock-picking, index funds charge a far lower management fee than actively managed funds. In India, index funds, if you invest directly, charge annual fees as low as 10-20 basis points, while active equity funds charge 75 to 225 basis points. This makes an immediate difference to your returns.

Two, because index providers regularly replace the sectors and stocks in the index to reflect what’s current in the market, you needn’t frequently churn your funds, saving you capital gains tax.

Not individual dependent

When you choose an actively managed equity fund, PMS or smallcase, you’re essentially betting on the investing skills of the individual who is managing your money. But identifying the right fund manager to bet on is no easy task.

Managers who outperform markets in one bull market may not deliver in another. In India, it is also quite difficult to find fund managers who’ve stayed with one firm for 10-plus years. You may invest in a fund impressed by the skills or track record of its manager, but may find him quitting for greener pastures midway through your investment journey. The investing style and temperament of a fund manager can also make quite a big contribution to a fund’s ability to perform across market conditions.

On his quitting, performance can go downhill or change dramatically. Investing in index funds automatically take individual skills out of the equation, as your fund simply owns the stocks that figure in a broad market index.

Index investing is not a panacea, because the stocks that figure in the index are chosen more for size, market fancy and liquidity than their growth prospects or management quality. But, for investors who lack the time or skill to make more nuanced choices, index funds are a hassle-free way to bet on the long-term prospects of the Indian economy.