Recently SA contributor Larry Swedroe penned an article measuring the performance of Berkshire Hathaway (BRK.A) (BRK.B) against a portfolio of passive funds. The passive approach outperformed Berkshire during the time period Larry used, and he interpreted this outcome as evidence supporting his view that passive investing is the best approach. There are enough sharp people advocating passive investing and I pay careful attention to the passive vs. active debate, and I always try to keep an open mind. But I don't agree with Larry's approach or conclusion in this case.
A Flawed Comparison?
There are several technical issues with the comparison. The funds that outperformed Berkshire by the most were DFA's US Small Value (DFSVX) and U.S. Small Cap (DFSTX). The 15 years from 1998 to 2013 were a very good time to own small caps; the 15 years before that, not so much. Even so, it's not an apples-to-apples comparison. Small caps carry additional volatility (and risk, if you buy into the Fama-French interpretation) but this was ignored. Unlike the Dimension funds, any investor can buy or sell Berkshire in any amount at any time, without having to use (and pay) an advisor. Lastly, back-testing results can be easily manipulated by choosing a timeframe that suits the author's purposes. As several commenters pointed out, BRK did very well price-wise in the years immediately preceding 1999, and may have been overvalued at the beginning of the sample period.
The Broader Issue - Passive vs. Active
As Timothy M. David McAleenan Jr. has pointed out, from a stock picking perspective passive investing is kind of a misnomer. Someone has to decide which stocks a fund is going to buy. You can delegate the decision to the folks at Standard & Poor's or Russell or DFA, but either you or someone else has to make a decision about which stocks to include/exclude in a fund or portfolio.
The really important difference is this: When passive investors buy an asset class, they buy at whatever price the seller asks. And when they sell, they sell at whatever price the buyer offers. The "passive" is not about the choice of assets - again, someone has to choose them - it refers instead to passively accepting whatever price the market happens to set for those assets. In contract, an active investor considers a stock and its price and decides whether to buy, sell or hold. The difference between active and passive investing is as much about price picking as it is stock picking.
In some worlds, accepting the market price might be fine. After all, the institutions that dominate the markets have, in theory, the resources and expertise to make good decisions that result in rational prices. The world in which we live, however, continues to provide evidence that this does not always happen. From the dot-com bubble to mortgage-backed securities to the gold run-up, investors have consistently accepted prices that made no sense. And it doesn't seem to be slowing down. CEOs like Elon Musk and Reed Hastings have publicly announced that their own companies' stock prices are too high. Twitter (TWTR) is currently trading at some fifty times revenue. I don't buy the theory that "alpha" is a zero-sum game among active investors, but even if I did, how much of a deterrent could it be when some of them are behaving like this?
I believe many "active" retail investors today are simply people who have completely lost faith in the market. Passive investing - buying small pieces of thousands of securities we know nothing about at whatever price the seller sets in the hope that down the road we can sell them to someone else for a profit to fund our retirement - does not sound like a good plan. Graham and Buffett and Lynch, among others, offer for an alternative that makes sense to us. Buy quality companies at reasonable prices and watch them grow. Ignore (or exploit) the price fluctuations - focus on the company and its ability to generate earnings. And as a direct corollary, don't focus on achieving a superior total return to some benchmark.
Being both mathematically inclined and slightly OCD, I track my returns religiously. But I don't focus on them. I try, as much as possible, to focus on my process. I'm willing to bet the folks at Berkshire do the same thing. I don't think the shareholders would want it any other way.