Who Do You Think You Are? Warren Buffett?

 Six years ago, Warren Buffett – without a doubt, the smartest investor alive on the planet bet $1M (a negligible amount of money when you consider his fortune) and most importantly his reputation on the idea that Vanguard’s S&P index fund will outperform a selection of hedge funds by Protege Partners over the course of a decade.

 So far, Buffett’s el cheapo index fund is winning handily at 43.8% against average of 12.5% on Protégé’s fund of funds, as at the end of 2013.

No victory dance for indexers as yet though, there are four more years to go and who knows, the clever hedgies could pull some of their magic. But it doesn’t really matter what the outcome is, what I find intriguing that the world’s smartest investor was willing to stake his hard-earned reputation on such a dumb idea  in the first place.

When you think of it though…. perhaps it’s not such a dumb idea after all? If you take the trouble, like I did, to review the work of some of the smartest economists, including notably Nobel Laureates Harry Markowitz, William Sharpe, Robert Merton, Daniel Kahneman, Gene Fama and even Robert Shiller, you will quite easily see why placing a bet on index funds is in fact, a very clever thing and probably the best for the vast majority of clients.  (And in case you are wondering what Shiller is doing on that list, I found absolutely nothing in Shiller’s work to help me or anyone else for that matter outsmart the market consistently.  But if you do, please let me know!)

I picked these people because their work has been widely critiqued by their fellow academics and practitioners alike, and rightly or wrong their ideas seem to have risen to the top. I came to a simple conclusion years ago that I couldn’t possibly be smarter than any one of these people, let alone four or five of them. And I don’t know any adviser who is either, even though I have met some exceptionally brilliant advisers!

The overwhelming body of work on evidence-based investing should at least lead anyone to approach active fund management with a high degree of skepticism. I would go even further as saying that the default recommendation should be index funds and selecting active fund should be only and only where there is demonstrable evidence that it adds value. And by evidence, I don’t mean past performance! Active share and expense ratio are by far the best predictor of performance, but even then its a little more than guess work.

Yet, what I see is exactly the opposite. Somehow, everyone acknowledges picking a great fund in advance, is a very difficult thing to do, yet on individual level, they think they can.  As in ‘it’s so difficult most people get it wrong but I’m different!’ I get into these conversations on Twitter all the time with people who acknowledge that picking funds is very hard but somehow they think can they can do it better than everyone else.

I think this goes into the heart of the profession and the questions everyone of us has to answer is: what do you know that  about investing that Warren Buffett and these Nobel Laureates somehow missed? Really, who do you think you are?