Where Are the Customers’ Yachts?

A visitor came to New York and admired all the nice boats in the harbor. He was told that they belonged to Wall Street bankers, upon which he naively asked where the bankers’ clients kept their boats. The answer: They couldn’t afford them.

Manhattan across the bay from Liberty State Park. Public Domain image retouched by NR.

Warren Buffett reminded us of this story when he delivered an epic rant against Wall Street last weekend during the annual meeting of Berkshire Hathaway. Buffett unloaded what he called a “sermon" about hedge funds and investment consultants. Shortly put, Buffett thinks these players are usually a "huge minus" for anyone who follows their advice.

Here are a few quotes from Buffett:

"Supposedly sophisticated people, generally richer people, hire consultants, and no consultant in the world is going to tell you 'just buy an S&P index fund and sit for the next 50 years'. You don’t get to be a consultant that way. And you certainly don’t get an annual fee that way."

In other words, the consultant has every motivation in the world to tell you to do this or that – at the very least something else than just sitting on your hands – and you end up paying them a large fee. Cumulatively fees eat up capital like crazy.

"I’ve talked to huge pension funds, and I’ve taken them through the math, and when I leave, they go out and hire a bunch of consultants and pay them a lot of money – it’s just unbelievable.”

Buffett thinks a passive investor whose money is in an S&P 500 index fund "absolutely gets the record of American industry" and that the "net result of hiring professional management is a huge minus."

Buffett is of course a celebrity in the financial world and often regarded as one of the best investors of all time. He is also well known for a hostile attitude against Wall Street, even though he's a ruthless a player in the game himself. But is he right or wrong in his critique of actively managed funds and investment advisors in general?

Many studies have been conducted on the performance of actively managed funds vs. passively managed index funds. Most of the studies and meta-studies (studies combining results from multiple studies) show that actively managed funds can’t beat their benchmarks over time, especially when you count in the management fees. If you want to dig deeper, you can start by checking out this study from Morningstar, this paper by Eugene Fama and Ken French, and this study by the Pensions Institute in the UK.

The performance of sell-side equity analysts has also been studied. These are the guys who work for a brokerage or a firm that manages individual accounts and they make recommendations to the clients – recommendations like the often-heard "strong buy", "outperform", "neutral" or "sell”. Studies show that no matter how much you pay for your recommendations, you’re not better off compared to using analyst reports issued by conventional brokerages.

Furthermore, studies reveal us that compensation for sell-side analysts is designed to reward actions that increase brokerage and investment-banking revenues. It reinforces Buffett’s claim that most of the "advice" you get from Wall Street is not designed for the benefit of the customer but rather for the benefit of the investment bank.

The story about the New York visitor was originally told by Fred Schwed 76 years ago in a book called "Where Are the Customers’ Yachts”. It's remarkable how well it still holds up after all these years.

I'll end this blog post with a quote from the book, which deals with the question who's to blame for poor advice: “The burnt customer certainly prefers to believe that he has been robbed rather than that he has been a fool on the advice of fools.”