In the past 20 years, investing in low-cost index funds like the S&P 500 has come to dominate much of the investing landscape.
The reason? It’s cheaper than investing in most mutual funds, there’s far less trading (which increases costs), and the primary structure that is used to invest in index funds — Exchange Traded Funds (ETFs), also have tax advantages.
No one can pinpoint the exact date when it became clear that investing in index funds had won out over investing in active management, but Warren Buffett declaring it to be so was certainly a pivotal moment.
The year was 2007. Buffett had entered into a bet with Protege Partners, a New York City money management firm that runs funds of hedge funds, that an index fund could beat an active manager.
Why Warren Buffett bet on index funds
The bet was this: Over a 10-year period commencing January 1, 2008, and ending December 31, 2017, the S&P 500 would outperform a portfolio of five hedge funds of funds, when performance was measured on a basis net of fees, costs and expenses.
Buffett, who chose the Vanguard Index Fund as a proxy for the S&P 500, won by a landslide. The five fund of funds had an average return of only 36.3% net of fees over that ten-year period, while the S&P index fund had a return of 125.8%.
In his 2017 letter to shareholders, Buffett took note of the high fees of hedge fund managers and offered what he called a simple equation: “If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win.”
His advice to investors: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
Why low-cost index funds could work for you
Buffett was saying something that had been known to savvy investors and traders for almost a century, but which had taken a long time to seep into the average investor’s consciousness: Active fund managers have a terrible track record.
Standard & Poor’s has been tracking the record of active managers for more than 20 years. Their mid-year 2022 report indicates that when adjusted for fees and for funds dropping out due to poor performance, after five years 84% of large cap actively managed fund managers underperform their benchmark, and after 10 years 90% underperform.
That is so bad that Standard & Poor’s, in a 2019 survey of the results, said the performance of active managers “was worse than would be expected from luck.”
Why does active management have such a poor performance? One issue is that the fees are too high, so any outperformance is eroded by the high costs.
A second issue: Fund managers often do too much trading, which compounds investing mistakes and also can lead to a higher tax bill.
A third problem: Most trading today is done by professionals who are trading against each other. These traders, for the most part, have access to the same technology and the same information as their competition. The result? Most have little if any informational advantage over their competition.
If Buffett, who is a skilled value investor, recognizes the benefits of low-cost index funds, it’s worth checking out for inclusion in your portfolio as well.
*Excerpted from the upcoming book, “Shut Up and Keep Talking: Lessons on Life and Investing from the Floor of the New York Stock Exchange,” by Bob Pisani.