As has been widely reported Warren Buffett frequently comments on the benefits of investing in low-cost index funds.
He’s reportedly instructed the trustee of his estate to invest in index funds. “My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund,” he noted in the Berkshire Hathaway’s 2013 annual letter to shareholders.
Not that I want to disagree with Buffett, I have enormous respect for him, incorporate many of his investment insights and philosophies into my own investment approaches. Albeit, I think he might be wrong on this account.
And this is not to say Index Funds do not have a part to play in a portfolio, nor that investment fees are not important. They are. I do think more portfolios should be invested along the lines of Endowments. Broad diversification is the key.
Following Buffett could be the right advice for a young person starting out with many years until retirement. Such an investor would need to weather the volatility of being largely invested in equities, which is no mean achievement when equity markets can suffer falls of over 40%. A high equity strategy can become horribly undone.
Nevertheless, as one gets closer to retirement and is in retirement Buffett’s strategy is unsuitable.
Similarly Buffett’s strategy is not appropriate for a Pension Fund or Endowment. These Funds are in a similar position to those in retirement. Meanwhile, the equity allocation should be reduced as one gets closer to retirement.
The short comings of a higher equity allocation was highlighted in a recent article by Charles E.F. Millard, who is a consultant to AQR Capital Management, LLC.
Once an investor needs to take capital or income from a portfolio volatility of the equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives.
The key point that Millard makes is that Pension Funds and Endowments are required to make periodic payment obligations. So do those in retirement, they either draw capital or income from the portfolio to sustain a desired standard of living.
Ultimately, it the drawing of an income or the payments by Endowments that consume most of the investment returns. “This is why assets don’t just mushroom over time.”
As Millard explains, “each year endowments usually pay out at least 5% of their holdings, and the institutions they support tend to count on those funds. That changes the situation an awful lot.”
Let’s look at the math. Millard explains”
”and assume that each year the endowment pays out 5% of its assets. In that case, starting at $1 million, the endowment would not have the $5.3 billion Buffett imagines. Rather, after having paid out almost $145 million along the way, the endowment would have less than $150 million remaining”
Still a great result, but far from the billions assumed by Buffett.
It is also worth noting that a Pension’s obligation (liability) can continue to grow as employees retire and live longer. The Pension Fund has no ability to reduce its payouts and must manage this risk.
This is where market volatility comes into play, particularly drawdowns – a large fall in the value of the market.
“In a prolonged stock market drawdown, those growing benefit payments will consume a larger share of the shrunken plan assets. So, they can’t take too much solace in long-run optimism when in the intermediate run they’re already paying out much of their capital.”
This is a key point. You can’t take comfort in the long-term returns from equities when you are running out of money!
Equity markets do fall in value and this is why institutions with meaningful annual pay-out obligations are not invested only in equities.
No argument that equities will not outperform over the longer term, this is highly likely. Yet this observation fails to recognise the volatility inherent in equities.
“Over Buffett’s 77 years investing, the endowment CIO would see fund assets decline in 23 out of 77 years (when equity returns didn’t cover the 5% distribution), and in the average bad year, the fund would shrink by -12%. But at least an endowment may be able to reduce its spending; a pension fund can’t, so in a bad year, the fraction of pension assets that must be paid out increases substantially. This is why most institutional investors subscribe to a concept that Buffett seems to hate – diversification. He’s said it’s “a protection against ignorance.” We think it is more a protection against hubris.”
Diversification is key.
“It is worth noting that Institutions do not seek to maximize potential long-term returns, without regard to risks. They often seek to maximize the likelihood that they can meet their payout obligations. They seek to be reliable payers of those obligations. And in the case of pensions, they also seek to make it possible for the employer to have somewhat predictable and affordable contribution obligations. A portfolio of stocks alone doesn’t do that. That’s why asset class diversification is a bedrock principle of modern investing.
In short, institutional investors have different goals and obligations to Buffett.
For those in retirement, their goals and obligations are more closely aligned with the Pension Fund and Endowment, than Buffett and Berkshire Hathaway. Those closer to retirement need to make sure that market volatility does not impact them and their ability to sustain the standard of level they wish to maintain in retirement.
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