This article by MOI Global instructor Ryan O’Connor is excerpted from a letter of Crossroads Capital, based in Kansas City, Missouri.
Our story begins not in Crossroads’ home of Kansas City, but in Omaha, when a young Warren Buffett set out on a path that would change both his and his investors’ lives. It’s a story that turns on an investment strategy that remains every bit as well-conceived and evergreen in 2020 as it was some 64 years ago. It’s also a story that goes to the very heart of our own mission, to who and what Crossroads is and aspires to be. After all, we’ve modeled our Fund after the investment partnerships managed by Buffett from 1956 to 1969, what we call “Buffett 1.0”. It was at this time that he established not just his reputation, but also an investment vehicle that was as unusual at that time as it was successful, and one that delivered his best years of performance relative to the market across his storied six-decade career. In fact, the Buffett LPs not only crushed the market consistently, they never experienced a single down year.
The reality is that none of what would eventually happen at Berkshire Hathaway would have been possible without those early LPs that served as the foundation for how the Oracle of Omaha built his wealth. What, then, makes those early Buffett LPs so instructive to investors like Crossroads who seek to create a similar hall-of-fame investment record? Let’s dive in and see.
When it came to outperforming the market, Buffett did pretty well (to put it mildly). But the vast majority of his active manager peers did not. In fact, they delivered pretty much the same outcomes in aggregate as they do today – mediocre returns at best, while charging high fees for the privilege. As a result, the ordinary investor seeking diversified exposure to common stocks who did not have the time, inclination, or expertise to do it herself had no other choice (index funds as we know them came on the scene around 1975).
Perhaps unsurprisingly, Buffett saw the structural flaws that compromised the industry-standard operating model from the very beginning. As his early letters attest, he understood that with fees, taxes, over-diversification, and psychology all working against the average active manager, the performance of actively managed trusts and mutual funds would fall far short of the broad market’s returns.
But that isn’t the only reason Buffett held the traditional fund management industry (and Wall Street more generally) in disdain from almost the very start of his career, when he started as a stockbroker working for his father.4 The issue for Buffett was simple: he didn’t like selling stocks because working on commission pitted his personal interests against those of his clients, and in doing so, flipped the role of a true fiduciary on its head. Buffett’s criticisms of the investment management industry have been often been labeled hypocritical. In fact, the opposite is true. As his Berkshire partner Charlie Munger would later put it:
Mutual funds charge two percent per year and then brokers switch people between funds, costing another three to four percentage points. The poor guy in the general public is getting a terrible product from the professionals. I think it’s disgusting. It’s much better to be part of a system that delivers value to the people who buy the product.
While we think there are many good people that do their best in this business, we’re not going to sugarcoat the issue. The situation is simply appalling. And as Buffett’s early letters attest, it’s certainly nothing new. In fact, most of the “risk management” and other common standards within the actively managed equity fund industry represent little more than the triumph of marketing slogans over truth. Indeed, we’d argue the contemporary industry is not only dangerous to your financial fortunes, it’s largely a thinly veiled wealth transfer mechanism whose secular decline is, candidly, long overdue.
The good news, though, is that more and more ordinary investors are figuring this out. Over the past decade, Main Street has shifted trillions of dollars in AUM from conventional actively managed equity funds to lower-cost passive alternatives run by investment firms like Vanguard. Main Street’s very sensible conclusion seems to be that if most active managers can’t beat the market, you might as well just join the market – not only will you likely end up with a better outcome, you’ll pay a lot less in fees along the way (the one by means of the other). As Jeremy Miller, the author of Warren Buffett’s Ground Rules explains, the traditional active management industry now seems headed for oblivion:
Today, all active investors, both professional and individual, have to outperform to justify their action. Most don’t. Many funds, especially the ones investing in hundreds of stocks at a time (Buffett calls these the Noah’s ark school of investing–two of everything), appear to be clinging to a business model whose extinction seems almost inevitable.
So, while it took decades for the active management industry’s chickens to come home to roost, at this point it’s clear that the industry as we’ve known it is in terminal decline. And frankly, we say good riddance. Why? Well, for one we’re not going to bemoan the disappearance of the wanton value destruction taking place at ordinary investors’ expense under any circumstances. In fact, far from being dismayed by value investing falling out of fashion, or the accelerating disruption taking place across conventionally managed equity funds, we’re thrilled. After all, the more active value managers who throw in the towel, the more opportunities there are for us to exploit. We’re reminded of how in the movie Forrest Gump, a storm destroyed all the shrimp boats that had been docked in the harbor. Only Forrest rode out the storm and emerged successful, with his competitors eliminated and the entire catch to himself.
But why do smart, well-staffed, well-resourced, well-connected, experienced investment managers so consistently fail to beat an unmanaged index? And how is it possible for a firm like Crossroads to beat the pants off them when they have a hundred times our resources, better access to company management, and teams of highly credentialed analysts? The truth is that traditional asset managers knowingly act in ways that undermine their own results, and they do this because they have no choice – assuming they want to keep their jobs.
We’re not exaggerating. Active mutual fund managers need to make sure that their results each quarter aren’t too far below that of whatever benchmark they measure themselves against or their ratings, as issued by companies like Morningstar, are likely to dip, which in turn will cause prospective retail and institutional investors alike to look elsewhere. And they need to do it while sticking to an often narrowly defined segment of the market, lest they find themselves accused of “style drift” by fee-skimming financial intermediaries who are generally glorified salesman essentially playing pretend. Even active hedge fund managers can feel the pressure of big institutional investors heading for the exits after a rough stretch of poor performance.
In other words, many active managers sabotage their own results because the business of investing is at odds with the craft of investing. And it’s easy to see why. The minute a manager trades owning 246 stocks in the name of “diversification” for a concentrated portfolio of best ideas, volatility will spike. When volatility spikes, investors get nervous. When investors get nervous, they leave. When investors leave, AUM goes down. When AUM goes down, management fee income goes down. See the problem? In short, it’s a vicious cycle that would require most funds to actually put their clients’ interests above their own. And for that reason alone, will never happen.
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