Why does Warren Buffett recommend you buying index fund

Shiro Miyashita, CFA
Investalent, LLC
Why does Warren Buffett
recommend buying index funds?
Copyright 2014 Shiro Miyashita

Buffett‘s advice to the trustee of bequests
In the 2013 letter to shareholder, Buffett uncovered his
investment advice to the trustee regarding his cash
bequest to his partner (67 years old) as follows;
“My advice to the trustee could not 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. (I suggest Vanguard’s.) I believe the trust’s
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.”

Human Capital vs. Financial Capital
• Invest in yourself first and raising your Human Capital

“Time” is the strongest power
you can equally utilize!
Had better starting early because;
• Enough time to recover from mistakes
• Getting wiser and reducing mistakes
• Realizing how costly is wasting your money & time
It’s easy to become “well-to-do” slowly

What do “sages” say?
“Well, I think the biggest mistake is not
learning the habits of saving properly early.
Because saving is a habit. And then, trying
to get rich quick.
It's pretty easy to get well-to-do slowly.
But it's not easy to get rich quick.”
Warren Buffet

Facts About Lottery Winner Bankruptcies
According to multiple studies,
• 44% of lottery winners had spent all of their
winnings within 5 years of winning the lottery.
• About 70% of all lottery winners end up going
broke and filing for a bankruptcy.
• About 1% of lottery winners will go bankrupt
every single year.
Source: BrandonGaille.com

What do “sages” say?
“Compound interest is the eighth wonder
of the world.
He who understands it, earns it ...
he who doesn't ... pays it.”
Albert Einstein

Real power of compound interest
Assume investing $10,000 with compound interest (5, 10, 15%)
x17.4
Compound
Interest 5％ 10% 15%
10 years $16,289 $25,937 $40,456
20 years $26,533 $67,275 $163,665
30 years $43,219 $174,494 $662,118
31 years $45,380 $191,943 $761,435
x66
x19.2
x76
x4.3 x4.5
The last year’s gain is huge!

Source: AAII.org
Jeremy Siegel “Stocks for the Long Run”
Gold Standard EndsGreat Depression

Inflation-adjusted Gold price index
Gold’s 2nd bull market is over around 2012.

Bill Gross said in 2013, “Bond bull market is over”

Source: AAII.org
How about
Real Estate?

MBS ABS
Multi-sector
CDO

Source: AAII.org
Stock is the best
for long term

• Not a “Zero Sum” game
• Everybody can win
• Stock index return is upward sloping in the long term since it is a
natural reflection of economic activities
Why the long term stock investment
is the safest bet?

Source: ”Stocks for the Long Run” by Jeremy Siegel
S&P500 index, Earnings, and Dividends during business cycle

• Compound Return plus alpha
• Stock return beats inflation（Long-term real total return 6.7％）
• Bond return is sometimes lower than inflation
is the safest bet?

Source : ”Stocks for the Long Run” by Jeremy Siegel
Even in the very high inflation year,
stock has the least negative return.
For any 30 years span, stock’s real return
is stably about 6 ～ 8%.
History shows that stock beats inflation
(1871-2007)

• Dividend re-investment is more powerful than compound interest
Why long term investment in stock index fund
is the safest strategy?

Invest $1,000 in stock in 1871 and hold until 2003 (No tax assumed)
Capital Gain is only 3% and 96% comes from dividend reinvestment
Source: ”Future of stock investment” by Jeremy Siegel
3%
96%
Dividend
Reinvestment
+ 1%
Capital Gain only vs. Dividend Re-investment
$90,000＋Dividend
Total Return
(Div. Reinvest)
Capital Gain

• Work as a “Protector” in a down time
• Earnings decrease and stock price goes down, however
company management has a motivation to keep dividend in
order to avoid the stock price collapse, then the dividend
yield goes up
• Even if dividend is cut a little bit, stock prices will decrease
more than that and dividend yield goes up anyway
• Since stock price is lower and dividend yield is higher,
dividend re-investment can buy more share than before,
and it increase accumulation of the share.
• Work as an “Accelerator” in an up time
• Thanks to the accumulation of shares in a down time,
return will accelerate in a up time.
• Dividend will increase when earnings increase in an up time
Stock market collapse is actually “good news” for a long
term investor who re-invests his dividend.
Why dividend re-investment is more powerful than
simple compound interest?
Source: ”The future for investors” by Jeremy Siegel

25 years the index return to the pre-Great Depression high
Real Total Return
If Great Depression did not occur
-40%
Capital Gain Only
The actual total return is much higher than it would
have been if the Great Depression did not happen
Source: ”Future of Stock Investing” by Jeremy Siegel

natural reflection of economic activities (cf. Appendix A1)
• Lower Risk, Higher Return
• Stock index is riskier than Bond in the short term, however, it become
safer than Bond if the term is longer than 10 years
is the safest bet?

Stocks
Risk & Return is liner in the short term
Bonds
T-Bills
Return
Risk
Risk free Rate
0
Risk & Return for T-bills, Bonds, Stocks
T-Bill=Treasury Bill

Stock never go minus
Stock is the safest
Worst Case
Best Case
Worst vs. Best of Inflation-adjusted Total Return

Risk-Return Trade-offs for Various Holding Periods (1802 – 2006)
Efficient Frontier

• Tax Saving
• Defer Capital Gain Tax until sold
• Long term capital gain tax is much lower than short term
is the safest bet?

How Deferring Tax Is Effective for Return
Note*: - In US, Capital Gain Tax for short term is personal income tax rate typically 20% to
35% while Capital Gain Tax for long term(>1yr) is 15％ typically.
- This scenario does not consider transaction cost
Assume both A and B invests in the same stock with
10％ return and the term is 20 years, and
A. Hold it until 20 years later and pay capital gain tax
when sold, the return is calculated as
[(1+0.10)20 -1](1-0.15*)+1= 5.87 times
B. Sell it at every year-end and buy back it at every year-
begin, the return is calculated as
[1+(0.10)(1-0.20*)]20 = 4.66 times
Difference between A and B is 1.2 times of the principal

• Dividend re-investment is more powerful than compound
interest
• Tax Saving
• Defer Capital Gain Tax until sold
• Long term capital gain tax is much lower than short term
is the safest bet?

• In 1974、John Bogle establish
Vanguard Group which provides low
cost mutual fund.
• In 1976, the world first index fund
“Vanguard 500” was announced.
• Now, they are the largest mutual
fund company.
One man has changed the world
If you say “diversified stock investment” in the past...
It meant buying active mutual fund with high expense
ratio. There was no other choice at the time.

• Many can’t distinguish between active fund and passive
fund
• Advisors of large firms recommends only active funds
because passive funds pay nothing to them
• When you ask your advisor about index fund, he/she
should show you a few active funds which outperformed
index fund in the past couple of years, and you would be
convinced to buy them.
• Even if knowing active fund cannot beat index in average
due to higher expense ratio, people still often
undervalue the magnitude of the result difference in the
long term, rather apt to ask big firm in order to feel safe.
The pitfalls for beginner investors

• Index Fund is a passive fund which mechanically copy
benchmark index portfolio
• It does not need a fund manager
• Its MER is low enough, and the performance of an
index fund is very close to that of the benchmark index
• You can easily check performance with news media
What is an Index Fund?

Market cap
Industry ETF covers REIT, Financial, Energy, Technology, Health Care, Transport etc.
Categorized ETF covers Large Cap, Mid Cap, Small Cap, Value, Growth, Blend etc.
Nasdaq 100
Dow 30
S&P500
Nasdaq Composite(3200)
Russell 3000
Russell 1000
Wilshire 5000(3678)
Major stock market index funds in US
Some stocks are included
in multiple indexes.
eg.) Apple, Intel, Microsoft, Cisco
are included in all major indexes.

Nasdaq 100 index holding

ETF
type
Mutual Fund
type
Real Time Trade  -
Limit Order  -
Short  -
Expense Ratio 0.05％～ 0.05％～
Transaction cost  (commission) -
Dividend re-investment  （up to Broker） 
Tax merit  
Two Types of Index Fund
ETF type vs. Mutual Fund type
No big difference, but Mutual Fund type is best for re-investment

• History shows the evidence that majority of the all
active mutual funds cannot beat index fund like
S&P500 or Wilshire5000 in the long term
• If you take the survivor bias into account, such
probability of outperforming index fund get worse.
• These trend was broadly observed in other countries
Why I can’t recommend active mutual fund?

Source:”Stocks for the Long Run” by Jeremy Siegel
（term：1972～2006）
How much % of mutual funds outperforms S&P500 or Wilshire5000?

(term: 1972～2006）
31%69%
Even if forgetting about survivor bias,
69% of all survived mutual funds cannot beat Wilshire5000

Sources: Morningstar and Vanguard

• Higher Fees
• MER(Mgmt. Expense Ratio) or fees(Frond-end/Back-end
load)
Why Active mutual funds cannot beat index fund?

Source: Vanguard calculations using data from Morningstar

Expense Ratios of Actively Managed and Index Funds
Sources: Investment Company Institute and Lipper
Basis points

The long-term impact of investment costs on portfolio balances
Assuming a starting balance of $100,000 and a yearly return of 6%, which is reinvested
Source: Vanguard
Just 65 basis point spread makes a big difference in 30 years

• Higher Fees
• MER(Mgmt. Expense Ratio) or Transaction fees(Frond-
end/Back-end load)
• Fundamental Issues
• Limitation by SEC regulations
• Cannot change fund strategy even if trend has changed
• Dilemma on seeking both higher return and lower risk
• The more diversify the portfolio seeking lower risk, the more
the performance get closer to that of the benchmark index.
• Winner’s curse
• The tendency that last year’s “best performance fund” is
the most popular this year creates big money flow into
the fund, which could be the main cause of lackluster
performance later
• Successful performance is mainly achieved by small portion
of super successful stocks and the fund manager have to
continue buying those stocks at higher price, and it affects
its performance negatively.
Why Active mutual funds cannot beat index fund?

Sector rotation is not efficient
And more, you cannot say who will be the winner next year

Number of Mutual Funds Leaving and Entering the Industry
2003–2013
Source: Investment Company Institute

Some of the Outflows from Domestic Equity Mutual Funds Have Gone to ETFs
Cumulative flows to and net share issuance of domestic equity mutual funds and ETFs, billions of dollars; monthly, 2007–2013
Note: Equity mutual fund flows include net new cash flow and reinvested dividends. Source: Investment Company Institute

• Choose low cost fund (around 10 bp)
• Choose well diversified fund
• Dow 30, Nasdaq 100 is not well diversified.
• Avoid overlapping
• If you buy S&P500 and Russell 1000, you’d weight on S&P 500
• Diversify industries
• Nasdaq composite is diversified but biased to high tech industry
• Buying multiple industry ETFs is not an efficient way
• Industry diversification is much important than country
diversification
• When you buy a US large stock, they do business globally
• Keep global investment less than 50% of your portfolio
• Avoid too much exposure to foreign currency/country risks
• Strong US dollar does not justify too much currency risk
• You may select “Small Cap Value” category as you like
Tips for buying index fund

Small-Cap Value vs. Small-Cap Growth

Small Cap Growth tend to outperform Small Cap Value in high tech boom period
Source: Federal Reserve Economic Data

Source: FactSet as of March 31, 2015. Annualized index data from March 31, 1995 to March 31, 2015.
Risk/Return Profile (Mar 31, 1995 ～ Mar 31, 2015)

Vanguard major index fund
Ticker Description ETF/MF MER%
VTI Vanguard Total Stock Market ETF (# 3629) ETF 0.05
VTSMX Vanguard Total Stock Market Index Fund (# 3629) MF 0.05
VOO Vanguard S&P 500 ETF ETF 0.05
VFIAX Vanguard S&P 500 Index Fund MF 0.05
VTHR Vanguard Russell 3000 ETF ETF 0.15
VRTTX Vanguard Russell 3000 Index Fund MF 0.08
VONE Vanguard Russell 1000 ETF ETF 0.12
VRNIX Vanguard Russell 1000 Index Fund MF 0.08
VBR Vanguard Small Cap Value ETF ETF 0.09
VSIAX Vanguard Small Cap Value Index Fund MF 0.09
VBR Vanguard Mid Cap Value ETF ETF 0.09
VSIAX Vanguard Mid Cap Value Index Fund MF 0.09
VTV Vanguard Value ETF ETF 0.09
VVIAX Vanguard Value Index MF 0.09
Ticker Description ETF/MF MER%
VGSH Vanguard Short term government bond ETF ETF 0.12
VSBSX Vanguard Short term government bond index fund MF 0.10

Keep away from IPO stocks
Buy & Hold Returns of 9,000 IPOs (1968 - 2001)

• Person who has stable salary is a “pseudo Bond”
• Young people should not have any bond.
• Old Rule of Thumb (bond allocation=age%) is
never justified
• Long term bond bull market has just ended now
• You cannot expect current near zero interest goes
lower, rather it’d goes higher
• Risk of living too long is much higher than that of
dying too early
• You should have an asset which overcome inflation
and have to make it grow until you die
Why Bond should be minimum in your portfolio?

1. If you need customized/optimized portfolio
2. If you need customized advise/consultation
3. If you need complicated tax consideration
4. If you wants to invest in individual stock, option, junk
bonds, shorting etc.
The fee worth paying is only for
“Customization and Consultation”
When do you need advisor?

• No Conflict of Interest
• No incentive to choose higher fee funds or accounts
• No quota, No product sales
• Should focus on client satisfaction and asset’s growth
• Pay only for optimization/customization of the
portfolio and consultation if needed
• He/she knows you very well, so you can expect
good and detail advise
Why independent advisors are good for you?

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