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Why Warren Buffett Thinks You Should Go Passive
Perspective | 30 October 2014
By: Peter Ng
Articles (81) Profile

One particularly interesting insight which was written in the latest shareholders’ letter of Berkshire Hathaway for FY13, was a strategy which Warren Buffett shared and proclaimed that could achieve long-term results, superior to those attained by most investors.

This strategy is as simple as investing 10 percent of an investor’s total investable funds into short-term government bonds and the remaining 90 percent into a very low-cost Standard & Poor’s (S&P) 500 index fund (he suggested one from Vanguard).

Passive Investing

These index funds which Buffett mentioned, are termed exchange traded funds (ETFs) where these funds could be formed with different objectives, but nonetheless offer almost the same type of benefits. The two main advantages are diversification and lower expenses.

As opposed to active stock picking where an investor handpicks a few stocks to include into his portfolio, an investor who invests in an index fund will be able to participate in the overall performance of the stock market. While some may argue that active selection could yield higher returns, and may be true if an investor is to be correct with his stock picks, however, if he is proven incorrect, the damage will be magnified due to concentration risks.

Even the most seasoned fund managers would dart the wrong picks. In the 1990s, an average diversified mutual fund returned an annualised 13.9 percent return compared to the S&P 500 which returned 17.3 percent.

Secondly, expenses for ETFs which are measured by expense ratios are generally lower than traditional mutual funds (or unit trusts in Singapore). Compared to the average expense ratio of 1.5 percent for a mutual fund, an ETF’s expense ratio is typically 0.25 percent and for Vanguard S&P 500 (mentioned by Buffett), it is 0.18 percent.

Smart Beta

Since the inception of the first ETF in 1976, more types of ETFs are created and introduced to the markets. One such type of ETF is known as alternative beta funds (also known as smart beta funds) which David M. Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices, has shared through an exclusive interview with Shares Investment.

Alternative beta funds are passively managed funds that encompass strategies apart from the traditional benchmark of inserting stocks of companies into a portfolio based on market capitalisation, shared Blitzer. These funds which emulate strategies which were once used by actively managed funds like mutual funds and hedge funds, have now been packaged into ETFs and conveniently traded on a stock exchange.

Blitzer noted that pursuant to the conditions of the economic environment, investors have differing appetite and preference for their investments. Alternative beta funds make the fit as they are almost limitless in customisation and the probability of an investor finding a desired strategy in the numerous options within these funds is likely to be high. Although the expense ratios of alternative beta ETFs are slightly higher than ETFs based on a conventional market benchmark, however, they are still significantly lesser than active funds.

One type of alternative beta funds that has attracted interests of late is low volatility funds. As the name suggests, these funds invest in a pool of low volatility stocks such as utilities and consumer staples. As these stocks are able to weather periods of volatility better due to their larger degree of earnings visibility, stock prices are likely to be more resilient compared to cyclical stocks. Considering the volatility in the market attributed to the rocky global economic environment, there are no surprises on the growing investors’ enthusiasm towards pursuing a defensive investment strategy.

As alternative beta funds are currently unavailable on the Singapore Exchange, a local investor would have to purchase these securities via an overseas exchange such as the New York Stock Exchange.

Backed by a strong interest in investments, Peter's research spans across a range of industries, with his focus placed on companies listed on the SGX.

Please click here for more information about this author.

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