#4: Warren Buffett is not an Index Hugger

Two weeks ago, the Financial Times (FT) Unhedged Newsletter (URL) joined many others to write about Warren Buffett and Berkshire Hathaway (BRK) in the week of its famous annual general meeting in Omaha. The FT also published an outstanding series on the future of Berkshire Hathaway without the now 93 year-old legendary CEO and Chairman (URL).

I stumbled across some statements in the two Unhedged Newsletters “Warren Buffett: The world’s richest index-hugger” (URL) and “Berkshire’s next move” (URL) from May 6 and 7, respectively. I have nothing qualified to say about Buffett’s succession, but I do believe the statement that Warren Buffett is an index hugger deserves some more discussion.

Before we go into that, let me give you the disclaimer. In 2015, a book about Warren Buffett sparked my interest in investing and I am admiring him ever since. I do not agree with everything he or his partner Charlie Munger say, however, I do believe there is a lot to learn from them. I am also a Berkshire Hathaway shareholder (unfortunately class B and not long enough) and just arrived back home from the annual meeting in Omaha last week. So I may be biased, but as a shareholder I am always interested in disconfirming evidence regarding my investment.

Berkshire Hathaway’s returns over the last 21 years

The FT, or for this newsletter it’s editor Robert Armstrong, start with a simple chart of BRKs cumulative performance versus the S&P 500 Total Return Index (S&P 500) over the last 21 years. The newsletter was published on May 7, 2024 and I replicate the chart below. Of course, it looks almost identical.

Own calculation and illustration. Data from financialmodelingprep.

Armstrong comments: “Over 21 years, the return performance of the S&P and Berkshire are all but identical. On an annual basis, their performance is five basis points apart (the S&P has the meaninglessly tiny advantage).” To the best of my knowledge, he doesn’t mention if he charts the A or B shares, but it doesn’t matter. I find an annualized performance of 10.58% for BRK.A, 10.57% for BRK.B, and 10.68% for the S&P 500. Slightly different than Armstrongs’ 5 basis points, but not worth bothering.1He probably uses a slightly different closing price. I use May 7.

There are some more statements in his first paragraph which I believe are worth looking at in more detail. For example, he writes that “Berkshire produces returns exactly like those of the large cap US index (this is true over five and 10 years, too).”

I don’t want to be overly meticulous, but we should change this sentence to “Berkshire produces [cumulative] returns exactly like those of the large cap US index (this is true over five and 10 years, too).” The total returns at the end of the sample period are indeed almost identical, but the road to the end is different. If you look at the chart above, there are clearly times when the S&P 500 is ahead and there are times when BRK is ahead.

I understand that Armstrong probably had that in mind and I fully agree with him that “Berkshire is such a large and diversified conglomerate, it would be odd if it did anything but hug the index.”

Indeed, BRK is now one of the largest US companies, a big constituent of the S&P 500, and active in a cross-section of US businesses. We shouldn’t expect the same performance as in BRKs heavily successful earlier years going forward. In fact, Buffett himself does not get tired to manage his shareholders’ expectations accordingly. All of this, however, does not mean that BRK is the same as the S&P 500.

Berkshire Hathaway’s “risk” over the last 21 years

As good investors, we know that return is only one part to evaluate an investment. Risk is the other one. Unfortunately, measuring risk is not as clear as measuring returns. There are countless individual views on risk. Armstrong rightly mentions this problem in his newsletter. I will postpone this discussion (see below) for a moment and continue with what Armstrong has to say about BRKs risk in the sense of academic finance: “Berkshire has a lower volatility (beta) than the market (somewhere around .7 to .8, where the market volatility is 1).”

This sentence contains three errors. First, he apparently uses volatility and beta interchangeably. Second, he writes that Berkshire has a lower volatility than the market. Third, he states that the market volatility is 1.

I don’t know if those are typos, but since he confused the terms twice in the same sentence, I assume it is on purpose. Volatility, by all definitions I know, is the standard deviation of returns over a time period.

Beta, in contrast, is the slope coefficient from the regression of an asset’s return on the returns of an adequate proxy for the market portfolio. To be super correct, we would also subtract the risk-free rate from both the asset’s and the market proxy’s return before running the regression. So technically, you only examine excess returns above the risk-free rate.

With that in mind, let’s look at some performance statistics for BRK and the S&P 500 over our 21-year sample period. I have to admit, however, that I am not super correct and did not subtract risk-free rates from the returns. It shouldn’t make too much of a difference for beta, though. The table summarizes the data.

Own calculation and illustration. Data from financialmodelingprep.

As clearly observable, Berkshire has a higher annualized volatility than the S&P 500. 20.57% vs. 18.86% for the A share, and 20.86% vs. 18.86% for the B share. The betas for the A and B shares are 0.71 and 0.75 respectively. This is within the range that Armstrong mentioned and indeed significantly smaller than the market beta of 1.2The absolute values of the t-statistics exceed all common significance thresholds. For example, 1.96 for a significance level of 5%.

What does this mean for the performance of Berkshire? Beta tells us how much a stock moves with the market. The market itself has a beta (not volatility!) of 1. Intuitively, when the S&P 500 increases by 1%, the S&P 500 increases on average by 1%. Genius! Berkshire’s beta of 0.75 suggests that the stock increases on average by only 0.75% when the S&P 500 rises by 1%. That is great for negative returns (market loses 1%, we only lose 0.75%) and bad for positive returns (market gains 1%, we only gain 0.75%).

Together with the cumulative returns, the smaller-than-one beta for BRK also tells us that the stock achieved roughly the same performance like the S&P 500 with considerably less exposure to it. That is great because as Armstrong rightly mentions, “[…] you could leverage an investment in Berkshire and make better long-term returns than the S&P […]”. That is the holy grail. Find investments with good risk-adjusted returns (high returns with low beta) and lever them to whatever cumulative return you desire.

Since BRK achieved higher returns than its beta suggests, Buffett and his team apparently generated alpha (URL). Technically, that is the intercept of the regression. Intuitively, it is the return that Berkshire achieved from sources other than just buying the index. Those alphas are with 3.64% for the A and 3.32% for the B share sizable, but not statistically significant (see t-statistics). So over this 21-year period BRK did generate risk-adjusted returns, but we cannot say with (statistical) confidence that this wasn’t just luck or randomness.

What is risk?

When we use beta as measure for risk, BRK was actually a quite good investment despite index-like returns. This is great, but Armstrong rightly raises the question if beta is the right measure for risk: “Buffett says – rightly – that for true long-term investors, volatility is a good thing, not a risk, because it provides opportunities to buy and sell at favorable prices.”

Since he (wrongly) used beta and volatility interchangeably before, I cannot say for sure what measure he is referring to. When we look at Warren Buffett’s 2011 Letter to Shareholders, however, his opinion on either of the two measures is quite clear.

The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period.

Warren Buffett (2012) – 2011 Letter – URL

So for Buffett and Berkshire, both beta and volatility are irrelevant risk measures. All that matters is the risk of permanent loss of capital or purchasing power. Armstrong takes on this issue and writes: “But it is not clear (to me anyway) what exactly he means by this, given that the S&P is a diversified index that growing companies automatically enter and shrinking companies automatically leave. Where is the risk of permanent loss in that?”

I agree with him. If we follow Buffett’s definition of risk, I would argue that the chance of losing purchasing power with BRK is probably higher than for a broad portfolio of 500 US stocks. So it is more risky. Before continuing, however, I want to look again at Buffett’s view on beta.

At all times, I attempt to have a portion of our portfolio in securities at least partially insulated from the behavior of the market, and this portion should increase as the market rises.

Warren Buffett (1961) – 1960 Letter – URL

The fact that this quote is from 1961 amazes me over and over again. That was just the time when academics started to think about beta and Buffett already implemented the concept in his partnership. I don’t believe he calculates betas of his investments. But I do believe that he (like all of us) prefers profitable investments that do not move with the S&P 500 over the same profitable investments that do move with the index.

A lower-than-one beta certainly doesn’t prevent permanent loss of capital, but it can be helpful. In my view, beta is therefore not a crazy measure of risk. It certainly ignores many relevant aspects, but if you offer me the return of the S&P 500 at a beta of 0.75 instead of 1, I take it.

Berkshire Hathaway in good and bad markets

Another way to examine the potentially permanent loss of capital are drawdowns. Armstrong takes the idea and examines how Berkshire performed during the downturn of 2007 and 2008. We could argue that Berkshire is less risky if it provides downside protection when investors need it the most.

I extended Armstrong’s anecdotal evidence and calculated maximum drawdowns and peak-trough-peak returns during all S&P 500 drawdowns of more than 10% in the sample period. On average, BRK had almost similar drawdowns and comparable recoveries. In this sense, BRK was therefore just as risky as the market and did not provide meaningful downside protection except for the drawdown in 2022. Having said that, I don’t believe this analysis provides much insight anyway. It is an ex-post scenario analysis of very different and cherry-picked situations.

Own calculation and illustration. Data from financialmodelingprep.

Armstrong arrives at the same conclusion and explains that although Berkshire outperformed during some difficult periods, it couldn’t position itself ahead of the index. He also mentions this in the follow-up newsletter on May 8, 2024: “[…] Berkshire did not permanently increase its performance edge on the S&P in the years surrounding the great financial crisis.”

In other words, why care about losing less when you still end up with the same return as the index? Well, that is what I mentioned above. The cumulative return is the same, but the road is different. All else equal, I think most people prefer a 10% return without temporary losses over the same 10% with a temporary drawdown.

In my view, however, just looking at some of the worst periods in 21 years does not provide the full picture on downside protection. A better way to measure the performance in good and bad markets are bull and bear betas.3Some also look at capture ratios. The idea behind those betas remains unchanged, but for the bull (bear) beta you only run the regression over data points with positive (negative) returns for the market index.

Own calculation and illustration. Data from financialmodelingprep.

This analysis provides much broader and more reliable insights on BRKs performance during good and bad times of the S&P 500. The data in the table shows that bull and bear betas are very similar and both are still significantly smaller than the market beta of 1.Bull and bear alphas, however, differ substantially. Bull alphas are heavily negative, -10.73% and -11% per year for the A and B share respectively. Despite the lack of statistical significance (see t-statistics), those numbers suggest that BRK tends to (strongly!) underperform when the S&P 500 does very well.

On the other end, bear alphas are insanely positive at 14.66% and 12.39% for the A and B share respectively. The t-statistics even show statistical significance at the common 5% level. This suggests that BRK tends to (strongly!) outperform on bad days for the S&P 500.

Bottom line: BRK did not protect you from the worst equity market drawdowns, but on average, it did strongly outperform on bad days for the S&P 500.4Note that this doesn’t mean that BRK makes a positive return when the S&P 500 loses. In most cases, it probably just loses less. All else equal, I think this is a great feature. You can of course criticize this bull-bear analysis as purely hypothetical, but this is the case with many ex-post performance evaluations.

Is Warren Buffett an index hugger?

Given all the analyses and what I mentioned throughout the post, I think it surprises no one that I disagree with the title of the newsletter “Warren Buffett: The world’s richest index-hugger”. I fully agree with the author that we cannot and should not expect materially different results from Berkshire than from the S&P 500 going forward.5Ignoring a potential mean-reversion from lower valuations for BRK compared to the index. Armstrong also rightly mentions this. Buffett himself agrees as well.

However, just because the cumulative returns over whatever period are similar doesn’t mean Buffet and BRK are index huggers. Berkshires beta-profile (I deliberately don’t use the word risk) is very different from the market as are its portfolio holdings.6In addition to all the returns-based arguments I bring here, we could also do a holdings-based analysis to see that BRK materially differs from the composition of the S&P 500.

One data point that I haven’t mentioned so far further illustrates that. The annualized tracking errors of the BRK shares relative to the S&P 500 are about 16% (see first table above). If Berkshire would be an active fund (which it somehow is), we would say that it is very active and far away from closet-indexing or index-hugging.

We all want outperformance and higher returns than the benchmark. However, I do believe the grown Berkshire Hathaway shows that a stock with index-like performance can still be an attractive investment. Again, if you offer me the cumulative performance of the S&P 500 without full exposure to it and with even better performance on bad days, I happily take it.

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1 He probably uses a slightly different closing price. I use May 7.
2 The absolute values of the t-statistics exceed all common significance thresholds. For example, 1.96 for a significance level of 5%.
3 Some also look at capture ratios.
4 Note that this doesn’t mean that BRK makes a positive return when the S&P 500 loses. In most cases, it probably just loses less.
5 Ignoring a potential mean-reversion from lower valuations for BRK compared to the index. Armstrong also rightly mentions this.
6 In addition to all the returns-based arguments I bring here, we could also do a holdings-based analysis to see that BRK materially differs from the composition of the S&P 500.