Warren Buffett’s business partner Charlie Munger recently offered an interesting insight into the success that he and Buffett have had over their investing careers. The vice chairman of Berkshire Hathaway was addressing the annual meeting of the Daily Journal Corporation, of which he is chairman.
Active money management, Munger said, has a horrible problem. After costs, hardly any managers are beating the market over the long term, “so we’ve got a whole profession that is being paid for accomplishing practically nothing.”
Of course Berkshire Hathaway is a notable exception. It has delivered market-beating returns over several decades, although in recent years even Buffett and Munger have struggled to outperform the S&P 500 Index.
Less is more
“We’ve done better than average,” said Munger, “and now there’s a question: Why has that happened? We tried to do less.”
Doing less is part of Berkshire Hathaway’s DNA. It’s all about investing rather than trading. It’s about staying within your circle of competence, waiting patiently for the right opportunity to arise, and, most important of all, resisting the temptation to trade too often.
As Buffett once put it, “calling someone who trades actively in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic.”
The industry’s overtrading problem
Unfortunately, the active fund industry has a serious overtrading problem. Typically managers turn over their entire portfolio every 1.7 years. I find that a staggering statistic. Apart from anything, how do managers seriously expect to carry out their responsibilities as shareholders, and influence company boards, if they only hold a stock for a matter of months?
More important from the investor’s perspective is the impact that overtrading has on net returns. The annual management charge is only part of what the investor pays. In many cases, transaction costs are even more significant. And because the investor doesn’t know, ahead of time, how often their chosen manager will choose to buy and sell, it’s impossible to put a figure on how much they will have to pay.
Possible causes of overtrading
So, why do fund managers trade quite so often? One suggestion is that it’s simply to justify their existence and the fees they charge. Another possibility is that some managers become mildly addicted to the adrenaline rush that trading and risk-taking can induce.
I personally suspect it has more to do with the asset gathering nature of the asset management business model, and the constant pressure on managers to meet short-term targets in order to maximise profits, keep their jobs and earn their bonuses.
Trading costs have risen
Whatever the reason for overtrading, it’s particularly costly to investors at the moment. New research by the market analytics firm ITG shows that trading costs globally reached a three-year high in 2018. The only regions where costs remained flat were emerging Europe, the Middle East and Africa.
Like Buffett and Munger, I’m not a fan of active funds for most investors. The odds of picking a manager, in advance, who will outperform the market just too high to make it worth the gamble. Index funds, which have very much lower management charges and transaction costs, are a much better option.
However, if you do choose an active fund, make sure it has a low management charge and, just as importantly, that the manager has a reputation for investing with conviction for the long term.
Some of the best performing active managers are those who place just half a dozen trades, or even fewer, every year — and hold their stocks for at least five or ten. For active managers, that’s about as romantic as it gets.
UK financial adviser? I’m going to be speaking at nine separate adviser events across the UK in March. There are still a limited number of places available if you would like to come along. You’ll find all the information here.