Lessons for Fund Investors from Buffett's Annual Letter

One of the most anticipated days of the year for many investment junkies is the one on which  Berkshire Hathaway's (BRK.B) Warren Buffett releases his annual missive to shareholders. There's a lot that fund investors can glean from his musings. And it's no different this year: Buffett's latest letter is filled with useful anecdotes and valuable lessons. Here are a few that I picked out from this year's letter.

Get the Basics Right
No investor is going to succeed without some discipline, and as Buffett points out, a large number fail to beat the indexes because they lack discipline. A good starting point, in his view (and one that we've long advocated), is a long-term commitment to a low-cost approach. To be effective at such an approach, trading on tips or sentiment (buying things after they've gotten hot and selling them after they've cooled) is best avoided. Moreover, limiting costs, particularly those associated with high management fees or excessive trading, is an important factor in getting the better of broad market indexes.

Keep It Simple
A simple truth is that investing isn't nearly as complicated as many people would have you believe. If it gets complicated, it's often because investors are trying to overreach for returns by putting money in investments that they don't really understand. As Buffett puts it: "Stay with simple propositions." In other words, build a portfolio that you're comfortable with and stick to investments and asset classes that won't keep you up at night. You'll be a lot less hassled and you're likely to do a whole lot better.

Tune Out the Noise
If you're paying too much attention to the financial media, there's a chance that you'll feel the need to act, even when doing nothing may be the best proposition. In that regard, learn from Buffett--on a weighted basis, Berkshire Hathaway's average holding period for  American Express (AXP),  Coca-Cola (KO),  Gillette , and  Wells Fargo (WFC) exceeds 12 years. Similarly, if you don't have the confidence to stick with an investment for an extended period of time, don't make it. And once you do make an investment, don't act simply because of what the headlines say. Instead, revisit your original thesis and determine if it is still intact. Act only if something has truly altered your original thesis.

There's Value in Diversification
Over the years, Buffett has been somewhat critical of those who diversify in an unrestrained manner. The argument, of course, is that you reach a point where you're only making your portfolio more indexlike. However, as his latest letter demonstrates, there is some value to diversifying sensibly. In particular, his negative views on the dollar are a reminder to fund investors with U.S.-heavy portfolios that it isn't a bad thing to devote some part of your portfolio to overseas investments denoted in foreign currencies. While there's no guarantee that even Buffett will be correct, he might be, so why not have at least a portion of your holdings out of the dollar?

Incentives Do Matter
An intriguing section of this year's report focuses on the incentives at one of Berkshire's subsidiaries, NICO. I won't go into the details, but Buffett pledged that no employees would be fired because of declining underwriting volume alone, a markedly different stance from peers. Rather, the unit emphasizes discipline when it comes to the underwriting process. So what does this have to do with fund companies? The incentive/compensation structure of a firm determines in large part the way it's run and the way funds are sold to investors. When the focus is simply on sales and gathering assets, chances are that investors will be underserved. You're much better off going with a firm that's more interested in explaining its investment philosophy--and sticking to it even in the worst times--than one that's committed to hawking returns.

Independence Isn't a Silver Bullet
Returning to a favorite topic, Buffett makes the important point that just having the label "independent" doesn't mean a board member's interests are aligned with those of shareholders. Even an independent director has an incentive not to rock the boat because they often draw significant compensation from the firm or the funds they are overseeing. As such, the way to judge a board's performance is by its actions. In the fund world, that means that even as more independent chairpersons take their new positions, the initiative's success shouldn't be measured until we can evaluate whether it truly changes behavior.

On an Unrelated Topic….
In last week's Spy, I broached the topic of performance fees and their value. I received a number of responses, but one in particular is worth sharing. The writer points out that there is one other structural impediment that dissuades widespread performance fee usage. That impediment is revenue sharing (a topic my colleague Eric Jacobson recently wrote about). Revenue sharing demands that fund companies “share” 20 to 50 bps for “shelf space” with fund supermarkets and others. As such, it's entirely possible that in a year when the fund doesn't earn its performance fee, a fund company could be paying more money for access to a distribution platform than it is earning. Clearly, few fund companies are going to accept that outcome.