Active versus passive investing: What Buffett thinks and why it matters for you

Warren Buffett’s most famous advice is to buy companies with strong moats when they’re available at reasonable valuations. But do you know his second most famous piece of advice? Buy a low-cost index fund.

That’s right. Despite building his wealth through active stock investing, Buffett advises the average investor to pursue a passive approach.

Guess who’s taking Buffett’s advice seriously? The Indian mutual fund industry. With the market booming, the industry is capitalizing on the momentum by launching a slew of new funds.

In fact, a leading daily reported that around 170 new funds have launched this year alone. Surprisingly, passive funds lead the way, with 42 index funds and 36 exchange-traded funds (ETFs) introduced so far. Together, these make passive funds the single largest category of the year.

Before we dive further, let’s clarify active versus passive investing.

Active Investing: This approach involves portfolio managers carefully selecting stocks based on research into fundamentals and valuations, aiming to outperform the benchmark index like the Sensex or Nifty.

Passive Investing: Here, the goal is not to beat the index but to mirror its performance. For example, a Nifty index fund buys all Nifty stocks in the same proportion as they appear in the index.

With definitions clarified, let’s move forward.

Active investing is often considered worthwhile only if it delivers at least 3-5% higher returns than the benchmark after fees. For example, if the benchmark yields 15% annually over a decade, an active manager should aim for 18-20%.

Are active fund managers in India achieving this? Let’s see.

Over the last 10 years, the BSE 100 index has returned a CAGR of 13%. I checked 23 large-cap funds on Moneycontrol, each over a decade old, and found their average 10-year return stands at 14% CAGR.

In other words, while the BSE 100 earned 13% annually, these funds achieved only a slight edge with 14% per year. Ideally, they should have averaged 16-18% for active management to make sense, but they didn’t.

Interestingly, none of these funds hit 18% CAGR over the decade, and only two managed 16%.

This performance shortfall explains the growing popularity of passive funds in India. If active managers can’t consistently outpace the index, paying them higher fees loses appeal.

So, should investors abandon active investing in favour of passive strategies?

In 1984, Buffett delivered a presentation titled The Superinvestors of Graham and Doddsville, where he spotlighted a group of 10-15 active investors who consistently outperformed the benchmark by 5% or more.

What set them apart? They followed value-investing principles taught by Benjamin Graham.

Graham’s core tenets included treating stocks as businesses, calculating intrinsic value, viewing the market as a fluctuating entity driven by fear and greed, and, crucially, maintaining a margin of safety when buying.

The 10-15 “super investors” Warren Buffett referenced closely adhered to these principles. Each held a unique portfolio, yet every stock they bought was evaluated for intrinsic value, acquired during periods of market fear, and secured with a margin of safety.

While their stock-picking methods varied, their foundational approach was the same: they followed Graham’s principles.

If you aspire to beat the market by at least 5% annually as an active investor, it’s wise to follow Graham’s approach. Buy only those stocks whose intrinsic value you understand, especially when others are fearful. And always ensure a margin of safety, so even if your assumptions prove wrong, your risk remains limited.

As Warren Buffett once said, “Follow Graham, and you will profit from folly rather than participate in it.”

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com