Low-cost investing wins over the long-term

Seven years ago investing guru Warren Buffett made a $1 million wager with Protégé Partners. He bet a small fortune that Vanguard’s low-fee S&P 500 index fund (VFIAX) would beat a five-hedge fund portfolio selected by Protégé over the following decade.

Fortune’s Carol J. Loomis has been keeping track of the results and she reported earlier this week that Mr. Buffett was still in the lead. At the end of the year, the index was up 63.5% so far and the hedge fund portfolio trailed behind with gains of only about 19.6%.

The bet didn’t start off well for Mr. Buffett because the first year coincided with the market collapse in 2008, which saw the index fund tumble 37% and the hedge fund portfolio slump 24%. But the tide has turned heavily in Mr. Buffett’s favour since then.

No matter who wins, a tidy sum of cash (originally $1 million and now closer to $1.7 million) will be donated to Girls Inc. of Omaha.

Why did Mr. Buffett think the index would win? Because costs matter when it comes to investing.

Low-cost index funds (or exchange traded funds) give investors a big leg up against the vast majority of actively managed funds that charge more than 2% of assets annually because most of the active funds fail to earn back the fees they charge.

When it comes to fees, hedge funds are sort of like regular active funds on steroids. While the details vary, many hedge funds charge 2% of assets annually plus 20% of any profits they generate. That represents a huge hurdle and most hedge funds fail to meet it.

The large fees charged by hedge funds tilt the odds in Mr. Buffett favour and, so far, the contest is playing out just as expected. But that’s not to say he can’t lose. There is still a chance the index will stumble and the funds will surge, but it isn’t a very big one.

The lesson here is that active investors should be mindful of the costs they face. I’m not saying they should give up on stock picking and buy indexes instead. (Mind you, that would be a good option for many investors.)  I am saying that it’s important for all investors to try to reduce investment fees and costs where possible.

For instance, if you like active funds, you can find good active managers who don’t charge an arm and a leg. You just have to look for them.

If you like to buy individual stocks then think about moving to strategies that don’t involve a great deal of trading.

No matter how you look at it, frugality is a winning strategy for investors over the long term.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of Jan. 30. The list is a good starting point for those who want to put some money to work this week.  Just keep in mind, the idea is to hold the stocks for at least a year after purchase—barring some calamity.

Notes:

Source: Bloomberg, Jan. 30, 2015

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)

New & Noteworthy

10-year expectations for asset class returns

Research Affiliates doesn’t have high hopes for balanced portfolios. They expect a passive one composed of 60% stocks and 40% bonds will gain an average of 1.2% per year, adjusted for inflation, over the next 10 years. Even worse, the gains don’t include fund fees.

Just For Fun

The board game of the alpha nerds

Looking for a relaxing game? Be sure to read about Diplomacy before you give it a whirl.