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The Warren Buffett-approved alternative to stock-picking

The most recent Berkshire Hathaway Inc (NYSE: BRK-A, BRK-B) letter to shareholders contained a number of pearls of wisdom, including one surprising admission: Mr Buffett’s will contains instructions that 90% of the remaining cash bequeathed to his wife is to be put into a low-cost, U.S.-based S&P 500 index tracking fund.

The legendary investor stated that, “long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

Although this is a rather startling admission from an investor many regard as being one of the best of our times, this is not a new strategy. In fact, this is part of an old debate, one that has attracted quite a lot of commentary and research, on whether passively managed index tracking funds perform better than actively managed funds.

According to a recent S&P Indices Versus Active (SPIVA) report, the S&P 500 Index outperformed 72.7% of all large-cap U.S. equity funds over a five-year period. Its Australian equivalent, the S&P/ASX 200 (ASX: XJO), outperformed 60.4% of Australian equity funds over the same timeframe (on a total return basis, which includes dividend reinvestments).

Exposure to the S&P 500 index can be accessed via the ASX-listed iShares Core S&P 500 Exchange Traded Fund (ASX: IVV), costing a paltry 0.07% per annum management fee (plus brokerage costs). On a total return basis, the iShares Core S&P 500 ETF has returned 14.9% per annum over the past five years.

Readers may also wish to consider investing in the Australian S&P/ASX 200 Index through the SPDR S&P/ASX 200 Fund (ASX: STW), which has moved in a similar fashion to the S&P 500. On a total return basis, the SPDR S&P/ASX 200 Fund has returned 14.6% per annum over the past five years, and has a management fee of 0.29% per annum.

The two broad-based ETFs mentioned above represent broad diversification tools and provide for an easy way to access the wide gamut of businesses across the spectrum of each respective benchmark index. In addition to these broader index trackers, there are also a multitude of ETFs that investors can consider to gain exposure to specific sectors such as global healthcare stocks through the iShares Global Healthcare ETF (ASX: IXJ) or commodities through the BetaShares Commodities Basket ETF – Currency Hedged (Synthetic) (ASX: QCB).

Risks

Investors should note that there are some risks to be aware of. The ETF could suffer from tracking error, a situation where the ETF does not exactly follow its benchmark index, or it could have a price mismatch, a situation in which its Net Asset Value (NAV) deviates from its market price.

There is also the risk that exchange rate fluctuations may affect the value of the portfolio if it is not currency-hedged. Market risk such as liquidity issues may make buying or selling ETFs difficult. Additionally, some ETFs may be “synthetic” and use derivatives/swaps to increase its index tracking accuracy which may lead to significant counterparty risk (the risk that the ETF will lose money if a third party to the swap or derivative does not honour their commitment).

Foolish takeaway

Although past performance is not an indicator of future results, in the long run, the statistics seem to indicate that a large percentage of managed funds have failed to beat their benchmark index.

For the many investors who are not interested in spending an inordinate amount of time scrutinising, analysing and researching companies or managed funds, an index tracking fund may prove to be a good, low-cost alternative. Given the multitude of ETFs available to investors, it would be prudent to do some further research into each type and understand the specific risks involved.

Recent ruminations by the “Oracle of Omaha” in Berkshire’s latest shareholder letter and the longer term results above demonstrate that investors may do well to consider index tracking funds as alternatives to investing in individual stocks or in actively managed funds, or as additions to round out a stock portfolio.

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Motley Fool contributor Sid Narsey does not own shares in any of the companies or exchange traded products mentioned in this article. 

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