The other day I opened Yahoo! Finance to find an article on an investment Warren Buffet made about eight years ago. The article outlines a bet between Buffet, famous CEO of the conglomerate Berkshire Hathaway, and Protégé Partners, a New York hedge fund. In 2008 Buffet bet that he could put $1 million of his own money in a simple index fund and over ten years it would outperform any other fund his opponent chose.
Well, it’s been eight years so far and Buffet’s fund is up 65.7% vs. 21.9% for the five individual funds the mutual fund company chose. In the beginning people likened this race to the tortoise and the hare. A straight-forward, uncomplicated fund that tracks the S&P 500 and a group of funds that try to outpace the S&P 500. It seems we just about have our answer to this ongoing debate.
People ask me about investing advice all the time and I generally say that you should put money in the stock market through your Roth IRA or 401k retirement accounts first. If you have an emergency fund and still have money left over then you can think about stocks and bonds. But before you go out and put your hard earned money in mutual funds you should understand what you’re getting into. Allow me to tell you about my favorite fund type and how it works.
The Humble Beginnings of the Index Fund
The first index fund was created in 1976 by a guy who believed in investments with low fees. John Bogle, also founder of the highly respected investment company The Vanguard Group, felt that people pay too much for advice and that often money managers didn’t do any better than the market as a whole. His research at Princeton suggested that the funds with the lowest expense ratios performed better than the more reputable, high expense funds. That first index fund, initially called the First Index Trust, was a runaway success. By 1982 other companies were looking toward adopting the index strategy. Today there are hundreds of index funds in existence and Bogle’s Vanguard Group manages about 3 trillion dollars in assets. All this began with the founding principle that people should pay less, and if they pay less they’ll make more.
How Indexing Works
There are lots of index funds out there today which try to trace some area of the stock market. The most basic index fund, Vanguard’s S&P 500 Index Fund (VFINX), selects stock from the 500 top companies in the U.S. by market share. The index fund is not actively managed which means no one is analyzing it to try to buy stocks that make the investors money, instead the fund is just designed to do exactly what the market does; if the market goes down the fund will, if the market goes up the fund will. The beauty is that index funds have such low fees. An index fund could cost you as little as .20% vs. an actively managed fund that costs 1.00%.
Here’s a simple table to show how a higher expense ratio can affect your returns over the life of a retirement account
|Expense Ratio||Annual Contribution||Annual Return||Compounded over 30 years||Lost Return|
In your average non-index fund there will be a money manager who selects stocks to buy within the fund, which may change over the course of time. That money manager is paid to try to figure out which stocks might be undervalued or which stocks could be sold that aren’t making their investors money. This buying and selling within a fund tends to cost investors money, as does paying the guy to manage it. Because this regular mutual fund costs more it actually needs to make its investors a higher return. The fees on funds drag down investment returns especially over the long term and this is something that’s well understood by those who choose the index fund.
You Get What You Don’t Pay For
This is by now a famous adage in index fund investing. The world of investment is all about that bottom number: the return. If you pay less for a fund you get to keep more of your money. The job of a money manager is to try to beat the market, and for that effort the money manager gets a bigger chunk. The trouble is, most money managers don’t beat the market and if they do it’s not sustained. It is incredibly difficult to know where the stock market is going or where the inefficiencies are. The index fund says, better to just track the market because it’s incredibly efficient. It’s a better game to try to match the success of our 500 strongest companies and pay low fees than to pay high fees to try to outsmart it.
From the tone of my blog post I’m sure my readers can tell I’m a proponent of index investing. In our current financial climate of tiny stock market returns in a wavering economy it truly is an important time to pay less for your investments. Apparently Warren Buffet thinks his investment in an index fund is going to outperform funds with higher fees and so far it seems he’s been right. I see our country moving toward free services in many ways. Think about your free Spotify music, free movie streaming, free budget calculators, free tutoring. All these things aren’t actually free but we’re shifting the way we pay for things through ad revenue. Millennials don’t want to pay for anything if we don’t have to and society is changing rapidly to meet our demands. Investing is no different. So the next time you have the option to change your retirement investments or you’re looking for what put your money in, just look at that expense ratio column. The lowest one will be the index fund and that’s where your money should be.
If you’re interested in the ongoing competition between Buffet and Protégé Partners I found this really cool assessment and discussion on longbets.org