Lessons From Warren Buffett's Succession Plans
The financial world was abuzz this week when Warren Buffett announced that a little-known hedge fund manager was the leading candidate to take over Berkshire Hathaway's investment portfolio when he eventually steps aside. Until that time, Buffett said, Todd Combs will undergo what I can only imagine is one of the most nerve-wracking apprenticeships ever as he oversees a "significant portion" of Berkshire's portfolio.
As fun as it is to speculate on the likelihood of Combs' success in following one of history's greatest investors, the story has important implications for mutual fund investors who choose to use actively managed funds.
There's no denying Buffett's long-term success. From 1965 through 2009, Berkshire Hathaway has produced an average annual return of 20.3 percent, more than double the S&P 500's 9.3 percent return. To put that in perspective, $1 invested in Berkshire Hathaway in 1965 would have been worth $4,092 at the end of 2009, while $1 in the S&P 500 would have been worth $55. Not bad.
Buffett's success is often the first thing investors point to in justifying their search for a superior mutual fund manager. If Buffett can do it, the logic goes, then there's a chance I can find someone else who can. The problem with that logic is that it overlooks the fact that Buffett, by and large, isn't just picking stocks he thinks will outperform -- he's taking over entire companies. He's not simply an investor; he's the owner.
Further, in making these acquisitions, Buffett is able to negotiate extremely favorable terms for Berkshire. He's often said that he's not interested in doing business with an owner who's interested in wringing the last possible dollar out of the sale of their firm. Those owners sell to Buffett because of his stellar reputation, and the fact that he'll largely stay out of their hair as they continue to run their companies (as long as they continue to be successful, obviously).
But leaving aside the issue of how appropriate it is to compare Buffett to a mutual fund manager, his announcement this week highlights an issue that investors in actively managed mutual funds absolutely have to worry about -- the longevity of their managers.
The average equity fund manager has a tenure of about seven years. If the typical investor's time horizon is conservatively estimated at 40 years (from the time they start working until they enter retirement), that means that they can expect to have six different mutual fund managers at their fund's helm.
Of course, most of us don't own just one fund. According to the Investment Company Institute, mutual fund investors hold a median of four funds, meaning that the typical investor can expect to have 24 different managers running their funds over their lifetimes. Obviously, it is the rare investor who sticks with their original four funds throughout their lives, and the number of managers they entrust their assets to will only increase as the typical investor cycles through funds over the years.
So if the odds of finding one manager who can outperform are low, the odds of finding 24 or more who will be able to do so over 40 years are ridiculously long. In his book How a Second Grader Beats Wall Street, my Moneywatch colleague Allan Roth calculated that a portfolio of five active funds has a three percent chance of outperforming an index fund portfolio over 25 years.
But I would argue that the odds are even lower than that, given the inevitable managerial changes that will occur during that period. Even if you find a star manager who's able to add value over a period of time, there's simply no way to predict how their successor will fare, as investors in Fidelity's Magellan fund have found in the nearly two decades since Peter Lynch departed.
Statistically speaking, the odds of finding two dozen winning managers during your lifetime aren't quite the same as the odds of getting struck by lighting with a winning lottery ticket in your hand, but they aren't 50/50 either. All the more reason to approach active management with a heavy dose of pessimism.
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