Warren Buffett. (Photo: AP)

When Warren Buffett speaks, investors listen — and active fund managers often cringe.

The Oracle of Omaha released his much-anticipated yearly stockholder letter on Saturday, emphasizing the upside of passive S&P 500 index funds.

Passive investors will “do about average,” like the S&P, he says. Active investors will likely have the same results but with “far greater costs.”

Thus, the active investors’ aggregate results after costs “will be worse” than those of passive investors.

“Costs skyrocket when large annual fees, large performance fees and active trading costs are all added” into the equation, Buffett explained.

While he acknowledges that there can be exceptions to the rule, investors overall “will do better with a low-cost index fund” than with funds of funds or some other active investments, he argues.

Not so fast, fund managers and active asset managers counter.

First, says Capital Group Chairman & CEO Tim Armour, Buffett and American Funds have more in common than not.

“Mr. Buffett’s approach at Berkshire Hathaway has many similarities to how we at Capital Group have built the superior track record of the American Funds through bottom-up investing, rigorously analyzing companies and building durable portfolios,” Armour said in a note to investors recently.

Second, Capital Group doesn’t disagree with the data that Buffett and others pointed to in forming their views.

In fact, Armour says, his firm acknowledges that the average investment manager does not “outpace the market over meaningful time horizons.”

But, he adds, not all investment managers are “average.” The executive notes: “Just because the average person can’t dunk a basketball doesn’t mean that no one can dunk a basketball.”

Value of Advice, Active Funds

While Buffett admits there are exceptions to his argument, Armour argues that Capital Group’s American Funds are “one of them.”

Working with a fund manager with a history that shows he or she may produce better results “can make a very meaningful difference in an investor’s life,” the executive explains.

Select funds give investors the chance to “outpace the index,” and over time “the difference between the market average and even 1% better returns … can mean a much larger nest egg for a retirement that could last decades,” he added.

Armour also argues that research “dispels the common myth that it’s impossible for an investment manager to beat the index.”

Investors can pick active funds with lower costs, which “can significantly increase your success rate.” Furthermore, funds with managers who are invested in these investments have better records over various time frames.

“Of course nothing is certain, but a long history of delivering superior results suggests it’s not just about luck. Like Mr. Buffett, our firm is 86 years old,” Armour stated.

Across American Funds’ 18 equity products, the fund family has averaged 147 basis points annualized “above the relevant index benchmarks even after all fund expenses,” he said.

The executive also believes that index funds don’t give investors a buffer against down markets.

“Actively managed investments like the American Funds offer the potential to lose less than index-tracking investments during market declines,” he said.

Moreover, advisors and asset managers “help motivate people to save and, perhaps most importantly, they can serve as a steadying hand during volatile times when human nature often drives investors to make decisions that wind up being counterproductive.”

While high fees and excessive costs are not helpful to investors, the good news today is that individuals have “more choices than ever in terms of how they seek and pay for advice.”

Passive Investing is ‘For Billionaires,’ Asset Manager Says

American Asset Management President and CEO Julian Rubinstein makes a different argument.

His view is that Buffett’s strategy “is for billionaires who can afford losses, not the average investor.”

For instance, the S&P 500 lost 65% from January 2008 through March 2009. “How many people can tolerate such sustained losses?” Rubinstein said in a statement. “Buffett’s idea of how to make the most money is great, unless the pain along the way causes investors to abandon the strategy. From that period, many investors never made up those losses.”

Instead, the money manager believes, investors should be able to both make money and avoid living through “tremendous deficits.”

By using some of American Asset’s strategies, he adds, an investor could have “made money” in 2008.

That same year, the value of Berkshire Hathaway stock declined nearly 32%. The S&P index dropped about 37%.

“Generally, when losses of that capacity with low-cost index funds happen, many individuals abandon their strategy, sell their assets and lose money that they can never seem to regain,” Rubinstein explained.

Buffet criticizes fund managers for profiting via high fees. But to the American Asset executive, money managers are really getting paid “to protect investors during a downturn.”

Asset managers are paid to “control risk,” to “design portfolios that are diversified and are not subject to 100% stock market risk” and “to know when it is time to reduce your holdings in an asset that is going down.”

While billionaires can watch money disappear, average investors “should be happy to pay for risk management,” Rubinstein said.

His group focuses on low volatility while remaining fully invested and protecting clients “no matter what the future holds,” he adds. 

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