The pace of innovation today has created a hyper-disruptive environment that constantly challenges and changes business and form factors. From omniscient ads that specialty retailers use to target every subconscious desire, to meatless meats now crowding out cows on grocery shelves, to USB cigarettes that plug into your laptop rather than your car lighter, seasoned businesses find themselves swatting at swarms of innovation. Even an industry as stubborn as asset management has succumbed, rendering stock-picking stars of the past unsure about their futures. To understand how Wall Street has eaten its own, let’s see how financial innovation has unbundled and repriced the great Warren Buffett.        

Buffett’s stock picking process contains three distinct functions. First, he decides where to look for investments: his “investment universe.” Second, he determines which financial attributes he prefers: his “quantitative screen.” Lastly, Buffett activates his perspectives and experience to evaluate “qualitative properties” like the knowability of the business, the quality of management, and the power of the brand. His stock picking process includes: 1) defining the investment universe, 2) developing a quantitative screen, and 3) applying qualitative judgement. Wall Street investment banks have cleverly packaged these steps into distinct investment products.

Step 1 Define the Investment Universe: Product 1 — Index Funds

For a fee of around .10 percent, you can now own just about any investment universe. There are hundreds of index mutual funds to choose from. The largest funds tend to track the Standard and Poors 500, which consists of the 500 largest U.S. companies sorted by size. This is where Buffett likes to shop. Investors should expect index funds to track their target index, consistently underperforming by the margin of the fee. With index funds, lower fees equal lower underperformance.   

Step 2 Develop a Quantitative Screen: Product 2 — Factor Funds

For a fee of around .25 percent, you can own only the stocks within an index that meet a tailored quantitative criterion. Factor funds deconstruct indices into groups of stocks with similar characteristics. Buffett’s portfolios heavily express value and quality quantitative factors while more growth-oriented managers emphasize size and momentum quantitative factors. Research reveals that grouping stocks within an index by certain quantitative factors (like value, quality, size, and momentum metrics) can generate excess performance over time.

Step 3: Apply Qualitative Judgment: Product 3 — Active Funds

For a fee of around 1.25 percent, you can hire a legendary stock picker to actively manage your portfolio. Now 1.25 percent may sound like a lot, but since 1964 Buffett has delivered 20 percent annualized returns for Berkshire shareholders versus 10 percent for the S&P 500 — more than covering his active management fee. However, the bulk of his outperformance occurred before the above innovations. In his own words, “Berkshire’s long-term gains [from here] will not come close to those of the last 50 years,” acknowledging that competitive product innovations have created serious challenges for stock pickers. In fact, according to Morningstar, only 23 percent of large cap U.S. value funds outperformed their benchmarks over the last five years, making the additional costs of active management questionable. Even for Buffett.

Bottom line: Fifty years ago, legendary active stock pickers like Buffett posted dazzling returns without much product competition. Today, index funds touting low costs, diversification, and tax efficiency have vacuumed up investor capital, making outsized gains elusive for most active managers. Fortunately, product innovators on Wall Street have combined the efficiencies of index funds with the fundamental judgment of active funds by creating factor funds — essentially granting everyday investors access to star stock pickers’ playbooks at a discount — an innovation even Buffett himself would have to endorse.

David S. Waddell is CEO of Waddell and Associates. He has appeared in The Wall Street Journal, Forbes, Businessweek, and other local, national, and global resources. Visit waddellandassociates.com for more.Wall