Buffett Asks Big Money: Why Pay High Fees?

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Poof: $100 billion disappeared.

That’s the figure that Warren E. Buffett recently calculated that pension funds, endowments and wealthy individuals have lost over the last decade to hedge funds and other money managers that charge sky-high fees.

“I believe my calculation of the aggregate shortfall is conservative,” Mr. Buffett wrote in his annual letter, released on Saturday to the shareholders of his conglomerate, Berkshire Hathaway.

The letter, which ricocheted around Wall Street to the consternation of some and the applause of others, was Mr. Buffett’s most damning assessment of the hedge fund industry to date, and it came amid a growing debate about whether professional money managers are capable of outperforming the stock market on even a semiregular basis.

As many investors know, recent failures of these managers to do so has caused all manner of problems — a devastation that Mr. Buffett described pointedly in his note.

“Much of the financial damage befell pension funds for public employees,” he wrote. “Many of these funds are woefully underfunded, in part because they have suffered a double whammy: poor investment performance accompanied by huge fees. The resulting shortfalls in their assets will for decades have to be made up by local taxpayers.”

For the past several years, Mr. Buffett has told anyone who will listen to avoid attempting to beat the stock market by investing in hedge funds or actively managed funds. Instead, he has counseled buying a low-cost S. & P. 500 index fund. (He has said he plans to advise the trustee of his estate after he dies to invest 90 percent of it in an S. & P. 500 index fund and the rest into government bonds on behalf of his wife.)

However, much of the biggest money in the nation hasn’t taken his advice and continues to pay enormous fees for underperformance.

In his letter, Mr. Buffett offered an unusually cogent, honest and blunt appraisal of the human behavior that drives individuals with money to avoid index funds — and their willingness to pay huge fees.

“The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it,” Mr. Buffett wrote. “Their money, they feel, should buy them something superior compared to what the masses receive.”

He continued, “The financial ‘elites’ — wealthy individuals, pension funds, college endowments and the like — have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars.”

Mr. Buffett said that wealthy individuals get drawn in by consultants selling them big promises. “Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S. & P. 500?” he wrote. “That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so.”

That advice, Mr. Buffett added, “is often delivered in esoteric gibberish that explains why fashionable investment ‘styles’ or current economic trends make the shift appropriate.”

Mr. Buffett’s index-loving advice may seem counterintuitive coming from a man who is considered the most successful investor in history — and who became so by actively making individual bets in the market.

It also may be hard to square given that millions of people follow Mr. Buffett’s words — and tens of thousands of them make an annual pilgrimage to Omaha to his annual meeting — looking for pearls of wisdom that they can use themselves to beat the market.

Mr. Buffett has long offered guidance about investing, and he often makes it sound easy. “Success in investing doesn’t correlate with I.Q. once you’re above the level of 25,” he once said — but it seems even he recognizes that some investors who follow his principles may not succeed.

“There are, of course, some skilled individuals who are highly likely to outperform the S. & P. over long stretches. In my lifetime, though, I’ve identified — early on — only 10 or so professionals that I expected would accomplish this feat,” he wrote.

Perhaps Mr. Buffett’s advice is being taken: Last year, according to Morningstar, about $505 billion flooded into index funds and exchange-traded funds; $340 billion was pulled from active money managers.

Of course, if everyone buys index funds, what would it do to the market?

Seth Klarman, a hedge fund investor whose recent letter to shareholders was much talked about, said of the trend toward passive investing: “The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”

And therein lies the rub: That inefficiency is where active investors like Mr. Buffett make money. “I’d be a bum on the street with a tin cup if markets were efficient,” Mr. Buffett once said.

Still, Mr. Buffett is not convinced the big money will take his advice and buy index funds — thereby giving up the dream of trying to beat the market.

“Human behavior won’t change,” he wrote. “Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something ‘extra’ in investment advice. Those advisers who cleverly play to this expectation will get very rich.”

Mr. Buffett observed: “This year the magic potion may be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: ‘When a person with money meets a person with experience, the one with experience ends up with the money, and the one with money leaves with experience.’”

I will be among several journalists and research analysts who will ask questions of Mr. Buffett and his partner Charlie Munger at Berkshire Hathaway’s annual meeting on May 6. A live webcast of the meeting will be available on Yahoo Finance. If you have questions you’d like to suggest, please send them to me: arsorkin@nytimes.com.