Over the years, NBA star LeBron James has built an unlikely friendship with Warren Buffett, the CEO of Berkshire Hathaway.
The 86-year-old Buffett has been spotted courtside at Cleveland Cavaliers games wearing James’ #23 jersey. James has even called the billionaire investor “Uncle Warren.”
Not surprisingly, James has approached Buffett for investing advice. What did Buffett tell James to do with the millions of dollars he makes playing basketball? Buy index funds.
In the letter, the 86-year-old wrote at length about the value of investing in low-cost index funds and exchange-traded funds (ETFs) that track stock market indices.
He said that investors, no matter their net worth, should shun high-priced investment advisers who try to outperform an index and simply buy low-cost funds that aim to match an index’s performance.
“The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
So what exactly are index funds and ETFs?
An index fund is an investment fund that tries to match, or track, the performance of a given index, like the TSX or the S&P 500, according to Forbes.
Say the S&P, an index that features major U.S.-based corporations like Apple, General Electric and Coca-Cola, gains 10 per cent of value in a year.
If you’ve invested in an index fund tied to the S&P, then the value of your investment will go up 10 per cent too — minus management fees.
Most ETFs, meanwhile, also try to match the returns of large indices but are traded on the stock market.
Many people rely on mutual funds, which are investment funds where managers pool together investors’ money and put it into bonds, stocks or other assets, for a fee.
Higher-net-worth investors, meanwhile, also put their money into hedge funds, which try to maximize returns using strategies that mutual funds don’t.
Buffett says that index funds and ETFs offer a few advantages: for one thing, they cover a broad array of companies and industries.
But they’re also cheap.
Most ETFs that are tied to indices have management expense ratios (MERs) that are well under one per cent.
An iShares ETF that tracks Canada’s TSX Composite Index, for example, has an MER of just 0.06 per cent.
By contrast, some mutual funds can have MERs of two per cent or more.
Critics have long said that Canadian mutual fund fees are among the highest in the world.
There is also evidence that index funds actually perform better than most actively-managed funds over the long-term.
Justin Bender, a portfolio manager at PWL Capital, points to recent research by SPIVA, which found that index funds outperform the majority of managed mutual funds. According to SPIVA, more than 70 per cent of Canadian equity funds failed to outperform the TSX index over a five-year span. They also found that over a five-year period 90 per cent of U.S. large-cap funds underperformed the S&P 500.
Bender said some investors prefer active management since it can help limit losses during a bear market. But Bender said the better option is to change your outlook, learn to stomach market volatility and let passively-managed ETFs do their thing over the long-term.
“Everybody wants to complicate things but all the evidence shows that it probably makes a lot more sense to keep it simple and use a low-cost, broad-market fund and you’re guaranteed at least the market return minus fees,” he said.
Keeping it simple
Index-based portfolios are often referred to as passive investments but some work and discipline are needed to build a portfolio, Bender said.
He said investors need to consider their risk tolerance and tax situation before building a portfolio. Some of that work can be done with the help of an adviser, but a do-it-yourselfer can also build a portfolio with a modicum of research.
Once an investor builds a portfolio, they should rebalance assets periodically, Bender says.
Other than that, they shouldn’t do much else. One thing Bender says you shouldn’t do is pay attention to the daily ups and downs of the market.
“The best way is to shut off the news,” he said. “I think most people listen to the news a bit too much thinking it’s going to really educate them and give them a leg up on their investing strategies. But really it’s just a bunch of noise and it’ll probably not send them in the right direction.
“The political climate right now is the best current example. I think most people weren’t expecting markets to do as well as they have over the last few months. If they had made a decision to sell their U.S. equity holdings based on noise in the marketplace and not on their long-term strategy they would have made some big mistakes.”
Buffett says index investing is the best, cheapest and most efficient way for most people to invest. So why don’t more people choose to simply stick to index funds?
Bender said human psychology often gets in the way.
“People want to make it more complicated than it is,” he said.