(Bloomberg) -- Warren Buffett's sweeping endorsement of index investing is sure to sting the hedge-fund industry and encourage the stampede into assets that passively track the market.
In his well-read annual letter to Berkshire Hathaway shareholders on Saturday, he estimated that investors wasted more than $100 billion on high-fee Wall Street money managers over the past 10 years. He declared an early victory in his decade-long bet that a basket of hedge funds would fail to keep pace with an S&P 500 Index fund. And he called Jack Bogle, the Vanguard Group founder who pioneered low-cost market trackers, a "hero."
"The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients," Buffett wrote. "Both large and small investors should stick with low-cost index funds."
The message is already catching on. After years of underperformance, hedge funds are facing a revolt by endowments, pensions and other institutional investors that have decided they aren't getting their money's worth. Meanwhile, index funds have been on a tear. In 2016, passive strategies attracted $504.8 billion in new money, while active managers saw $340.1 billion in redemptions, according to data from Morningstar.
'MASSIVE RIPPLE'
"It offends his sensibilities since so many people have extracted so much from the system for so little net benefit," said Steve Wallman, a money manager in Middleton, Wisconsin, who has invested in Berkshire since 1982. The letter is "going to have a massive ripple effect. It always does. And it should."
Buffett's annual report built on a critique he's been making for years. In 2014, for instance, he wrote that he was planning to put most of the money he was leaving for his wife in a Vanguard S&P 500 tracker, saying it would outperform most people who hired high-fee managers.
Investors took his advice, and their enthusiasm hasn't abated. In the 12 months ended Jan. 31, the Vanguard 500 Index Fund had inflows of almost $38 billion.
The billionaire has made his point most visibly through a $1 million bet with Protégé Partners, which had said that hedge funds' ability to short stocks would give them an advantage in falling markets. Buffett challenged the asset manager to pick a group of hedge funds that it thought would beat an S&P 500 Index fund over 10 years. Proceeds from their wager go to charity.
WINNING BET
On Saturday, he gave an update: A $1 million investment in the bundle of hedge funds would have generated a $220,000 gain in the nine years through 2016, compared with the index fund's $854,000 increase. That means it's a near certainty Buffett will win when the bet ends on Dec. 31. The billionaire estimated that about 60% of the gains that the hedge funds produced during that period were eaten up by management fees, which he called a "misbegotten reward."
Beyond that critique, Buffett updated shareholders on progress at Berkshire, the now-sprawling conglomerate he's run for more than five decades. Profit last year was little changed at $24.1 billion, as earnings from newly acquired manufacturer Precision Castparts helped offset a decline in income from the company's railroad, BNSF.
He also pushed back against the assertion that share buybacks are "un-American" and offered a lesson in when they make sense. He criticized companies that adjusted earnings higher by omitting restructuring costs and stock-based compensation. And he again expressed his deep conviction that the U.S. — a country that combined "human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law" — would thrive over the long haul and be a profitable place to do business.
"It's a chord he's been playing for a long time," said Jeff Matthews, an investor and author of books about Berkshire. His message was, "Don't get too caught up in this stuff that everything we've been doing is wrong."
INSURANCE EXECUTIVES
Buffett also praised managers who run Berkshire's businesses, name-checking several in the company's insurance segment. But he made no detailed remarks on succession and was quiet on Wells Fargo, one of his largest stock holdings. The bank is working to recover from a phony-account scandal. Nor did Buffett discuss the rationale for profitable new investments in Apple and the four largest U.S. airlines.
Many of his fans have found his embrace of index funds jarring, not least because he continues to pick stocks at Berkshire and hired two former hedge-fund managers in the past decade to help him oversee the company's equity portfolio, which was valued at $122 billion at the end of 2016. Buffett also helped usher in the boom in active investing by writing for years about how fads and fear in markets can make securities available at attractive prices.
If Buffett added an index fund as one of his company's top holdings, "then there would be a sea change," said David Sims, president of Sims Capital Management, which holds Berkshire shares. "He absolutely is on the active side of things."
GETTING BIBLICAL
The billionaire threw a bone to that crowd in his letter, reiterating his stance that it's possible to beat the market and that some managers do outperform. But he also said it's hard to identify those who can. In his life, Buffett said, he'd only found "ten or so" early on in their careers.
He also tried to soften the blow to Wall Street. Buffett initially focused on stock picks at Berkshire but has shifted his strategy to buying whole businesses. In the letter, he said he was more than willing to pay fees — "even outrageous" ones — to investment bankers who delivered deals.
"To get biblical," he wrote, "I know the height and the depth and the length and the breadth of the energy flowing from that simple four-letter word — fees — when it is spoken to Wall Street. And when that energy delivers value to Berkshire, I will cheerfully write a big check."
