In recent years, the idea that investment managers can’t beat the index has become something of a truism within investing circles. The latest to weigh in is legendary investor Warren Buffett. In his 2017 letter to Berkshire Hathaway shareholders, he effectively endorsed that view by advocating low-fee indexing as the best approach for most individual investors. Here, Tim Armour, chairman and chief executive officer of Capital Group, which runs the American Funds, discusses Mr. Buffett’s views and offers his perspective on the indexing discussion.
What are your thoughts on Warren Buffett’s recent comments that seem to endorse index investing?
First off, it’s impossible to be an investor and not have tremendous respect for Warren Buffett and his track record. As an investor myself and someone who leads an investment management organization, I have a special appreciation for just how difficult it is to do what he’s done.
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. This research-driven, long-term, buy-and-hold approach means less trading, lower expenses and, in the case of the American Funds, index-beating results across our equity fund lineup.‡ And we wholeheartedly agree with Mr. Buffett’s all-important message that Americans need to save more for retirement ― and to get invested and stay invested.
Mr. Buffett is not the only indexing proponent. Why do you think this view is so prevalent?
It’s important to say that we don’t dispute the data that has led Mr. Buffett and others to form their views. Namely, we agree that the average investment manager does not outpace the market over meaningful time horizons. However, a fairly simple fact has gotten lost in the debate. Simply put, not all investment managers are average. As we like to say, “Just because the average person can’t dunk a basketball doesn’t mean that no one can dunk a basketball.”
Mr. Buffett and others acknowledge that there are exceptions. We are one of them. And selecting a manager whose track record suggests it has the potential to deliver better outcomes can make a very meaningful difference in an investor’s life. For example, investors in an index fund will generate market returns. On the other hand, by investing in certain select funds, investors had an opportunity to outpace the index. For today’s investors, the difference between the market average and even one percent better returns over the long term can mean a much larger nest egg for a retirement that could last decades.
How does an investor find above-average funds?
Extensive research dispels the common myth that it’s impossible for an investment manager to beat the index. Among the tools for identifying them are two straightforward screening criteria.
The first is expenses. Selecting low cost funds can significantly increase your success rate. Second, funds whose managers have “skin in the game” − put another way, managers who are invested in the funds they manage − have tended to do better over various time frames.
Using these simple screens identifies a select group of funds that have, on average, consistently outpaced benchmark indexes. This can help increase the probability of identifying some exceptional funds and screening out the rest.
Of course nothing is certain, but a long history of delivering superior results suggests it’s not about luck. Like Mr. Buffett, our firm is 86 years old. In fact, when we add up the history of our 18 equity funds, they have 653 years of investment experience. Across that span, in good markets and bad, we have averaged 147 basis points annualized above the relevant index benchmarks ― even after all fund expenses.‡
Do funds from certain managers offer something beyond the possibility of higher returns?
Index funds allow the opportunity to benefit when the markets are going up. However, by investing in index funds, you are also locking in all the market’s losses. Index funds may have their place, but they provide no buffer against down markets. Despite the trillions of dollars that have flowed into them, only about half of investors we surveyed last year are aware that index funds expose them to 100% of the volatility and losses during market downturns. Perhaps that’s unsurprising given the historic length of this bull market. But markets turn. And doing better than the crowd in bad times is critical for investors seeking to grow their nest egg over the long term. Actively managed investments like the American Funds offer the potential to lose less than index-tracking investments during market declines.
What’s your view on the value of professional advice?
The Capital Group has long believed in the value a financial advisor can bring to help investors pursue their long-term investment goals. We believe advisors 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. Americans need to save more and stay invested, and advisors play a pivotal role in helping people do both of those things.
The question of how advisory services are delivered and paid for is a different one. The good news is that people have more choices than ever in terms of how they seek and pay for advice.