In the past 20 years, investing in low-cost index funds like the S&P 500 has dominated much of the investing landscape. The reason?
It’s less expensive than most mutual funds; there’s less trading (which raises costs); and the primary structure used to invest in index funds — Exchange Traded Funds (ETFs)—has tax advantages.
No one knows exactly when it became clear that investing in index funds was better than investing in actively managed funds, but Warren Buffett’s statement that it was was a turning point.
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 does Warren Buffett bet on index funds?
The bet was that from January 1, 2008, to December 31, 2017, when fees, costs, and expenses were taken into account, the S&P 500 would do better than a portfolio of five hedge funds.
Buffett, who chose the Vanguard Index Fund as a proxy for the S&P 500, won by a landslide. The five funds had an average return of only 36.3% net of fees over those ten years, 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 Group A.” “Whichever group has the lower costs will win.”
He tells investors, “When Wall Streeters charge high fees to manage trillions of dollars, it’s usually the managers, not the clients, who make a lot of money.””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 known to savvy investors and traders for almost a century but that 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 report for 2022 shows that when fees for funds leaving because of poor performance are taken into account, 84% of large actively managed fund managers don’t beat their benchmark after five years. After ten 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 poor performance? One issue is that the fees are too high, so the high costs erode any outperformance.
A second issue: Fund managers often do too much trading, which compounds investing mistakes and can lead to a higher tax bill.
A third issue is that most traders in today’s market compete with one another. 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, a skilled value investor, recognizes the benefits of low-cost index funds, it’s worth checking them out for inclusion in your portfolio.
Courtesy: CNBC Make It