Investing in market index mutual funds, known as passive investing, is described as boring.
But the truth is in the returns: index funds routinely beat funds actively managed by professional stock pickers.
Last year was no exception, according to a new global research report from Bank of America. Funds managed by professionals have had a good time outperforming the returns of passive indexes that track large-cap U.S. stocks.
For example, only 36% of actively managed large-cap mutual funds in the U.S. will achieve gains greater than the Russell 1000 indices in 2024.
The Russell 1000, the stock index that provides exposure to companies like Apple, Nvidia, Microsoft, Amazon and Facebook’s parent company Meta, had a lot of traction behind it with these hot tech stocks, to be fair.
But it’s not a coincidence. Of the more than 1,900 U.S. stock mutual funds and ETFs tracked by Morningstar, 19% outperformed the S&P 500, which returned 25%, and only 37% beat the index of their category in 2024.
For two decades, S&P Dow Jones Indices has been producing “scorecards” that compare the performance of actively managed stocks and fixed-income mutual funds with different indexes over different time periods. In the past three years, for example, 86% of actively managed funds couldn’t match the S&P 500. Over 10 years, 85% of these funds Poor performance Standard & Poor’s 500, according to data.
One star fan of low-fee index funds is Warren Buffett.
“People will try to sell you other things because it will make them more money if they do. And I’m not saying that’s a conscious act on their part. Most good salespeople believe their own bullshit… That’s why I suggest people buy an index fund.”
Berkshire Hathaway CEO Warren Buffett walks around the exhibit hall at the company’s annual meeting in Omaha, Nebraska, on April 29, 2022. REUTERS/Scott Morgan ·Reuters/Reuters
I’m a big fan of investing my retirement savings in index funds because they’re simple and less expensive than picking individual stocks and bonds to buy and sell at the right time.
It is likely to ride Slides in the stock market If you stay the course in diversified baskets of stocks and bonds.
Sure, it’s more like having a nice cup of tea at Disney World’s Mad Tea Party than Max Force from Six Flags, but for most of us, it’s the ticket for the ride.
Investors who choose actively managed mutual funds typically pay higher fees than passive investors, which is surprising given the performance imbalance.
Calling investing in index funds a passive investment is also ideal, since the point of owning them is to cool your jets when the markets go bad.
Investing in index funds — balanced between stocks, such as the S&P 500, and fixed-income bond funds, and put on autopilot — has been classic advice for many investors, especially those dumping retirement money. And if you’re already retired, managing costs helps increase take-home returns.
“I anchor clients’ investments in a passive index strategy because history continues to prove itself that passive investments outperform active managers over a long period of time,” said Lazita Rennie Braxton, financial planner and founder of Real wealth groupYahoo Finance said. “Goals are consistently met in terms of investment without the added risk of trying to track and follow active managers who can get that extra return after their fees.”
While fees have declined in recent years, in 2023, index stock mutual funds had an average asset-weighted expense ratio of 0.05%, according to research by the Investment Company Institute (ICI), compared to 0.42% for actively managed equity mutual funds.
Index funds are in vogue these days. About 52.6% of mutual fund and ETF assets were in passive funds as of the end of November, compared with 49.6% in November 2023, according to research and consulting firm Cerulli Associates.
One big motivation for moving into index funds: increased investing in target-date funds.
I think many of you are already investing in index funds in employer-provided retirement plans like a 401(k). Virtually all 401(k) plan sponsors and the majority of state automatic IRA programs use target-date funds when they automatically enroll workers in a retirement plan.
These funds usually consist of index funds.
With a target date retirement fund, you select the year you want to retire in and buy a mutual fund named after that year (such as Target 2044). The fund manager then splits your investment between stocks and bonds, adjusting this to a more conservative mix as the target date approaches.
At Vanguard, for example, 83% of 401(k) participants used target-date funds, and 70% of target-date investors had their entire accounts invested in a single target-date fund. That’s up from 6 in 10 in 2022, and more than double the number in 2013, according to Vanguard.
“The passive approach has proven to work,” Zanelea Harris, a financial planner and president of Harris & Harris Wealth Management Group, told Yahoo Finance. (Photo courtesy of Zanelea Harris)
I reached out to financial advisors to get their take on the role index funds should play in retirees’ accounts. That’s why they love them too:
“The passive approach has proven successful because of consistency, increased contributions, time and compound interest,” Zanelea Harris, financial planner and president of Harris & Harris Wealth Management Group, told Yahoo Finance.
“John Bogle, the grandfather of passive investing, encouraged keeping it simple, easy and cost-effective,” she said.
But she also advises her clients to add some juice. “Some investors may take a more strategic approach to growing their retirement savings, such as adding a handful of individual stocks,” Harris said.
For Leo Chubinishvili, a financial planner at Access Wealth, it’s all about those basic fees. “Cost efficiency – Passive funds, like index funds, have lower expense ratios compared to actively managed funds,” he told Yahoo Finance. “Cost savings compound over time, benefiting retirement savers. Passive investments may reduce the temptation to make frequent adjustments based on market fluctuations.
For current retirees, index funds make sense for several key reasons, says Christine Benz, Morningstar Personal finance managerYahoo Finance said
“Managing a streamlined investment portfolio is important at any age, but it is especially beneficial as we age. Index funds provide you with broad market exposure in a simple package. You will never have to worry about management changes or portfolio changes with index funds.” The market is broad, and it is easy to see if rebalancing is in order and where it can be done.
“Reducing the moving parts in your portfolio makes life easier for your loved ones if they ever need to manage your money,” she added.
Tax advantages are another big reason to attract retirees. Index fund portfolios (particularly ETF portfolios) tend to have low tax costs, especially on the stock side, Benz said.
“Given that many investors’ portfolios are at their highest levels in retirement and include a large share of taxable and non-retirement assets, reducing the tax burden is another way to increase accrued returns,” she said.
One caveat: “Passive management is cheaper than active management, and it performs very well in a bull market,” said Cary Carbonaro, a management consultant at Ashton Thomas. “It’s in a bear market where it may not do as well.”
