The entire mutual fund industry was founded on one basic idea: that a smart investment manager will make you money. And this same manager will do better than the overall market. But this claim is not supported by the facts. Fund managers hardly ever do better than the market.
Every year, Standard and Poor's publishes a scorecard showing how many fund managers beat various stock market indices around the world. And every year the fund managers lose. Last year's scorecard showed that 84% of U.S. equity fund managers could not beat the market over the previous five years. Eighty-two percent could not do it over a 10-year period. For Europe, the number is 70%. For Japan, it's 60%. And it's the same for India. Basically every major market in the world beats the majority of fund managers over every time frame measured.
It's true some fund managers can beat the index from time to time (and these managers' marketing departments let everybody know when they do). Some can even beat the index for a few years in a row. But there are almost none that can do it consistently. The managers that on occasion beat their benchmark index are probably just lucky.
Plus, they're behind the index as soon as the year begins because of the fees they charge. If the average mutual fund has a management fee of 1.5%, the manager has to do better than the market by more than 1.5% each year to justify the fees he earns.
One successful investor who understands this, and wants everyone else to know it, is Berkshire Hathaway's Warren Buffett. What makes his viewpoint especially interesting is that he's one of the very few investors who has beaten his market benchmark -- in his case, the S&P 500 -- over time.
He doesn't outperform the S&P 500 every single year. But from 1965 to 2015, Berkshire Hathaway (which is sort of like a gigantic mutual fund, without the fees) had average annual returns of 20%. The S&P 500 "only" returned 9% a year over the same time period.
Mr. Buffett is now 85 years old. Like everyone should, he has drawn up a will with specific instructions on who gets what from his huge estate (he is the third richest man in the world). All of his Berkshire Hathaway shares will be given to charity.
But he will also be giving his wife some cash to be kept in trust, and these are his instructions for it:
"My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions or individuals -- who employ high-fee managers."
So even one of the most, if not the most, successful investors in history wants his wife's money to be invested in an index fund. Not actively managed mutual funds or hedge funds. The last part of his quote explains why: "high-fee managers." As we mentioned, that's one of the main reasons most people are better off owning an index fund or exchange-traded fund that tracks a stock market index.
We already discussed mutual fund fees. But the fees hedge funds charge are often higher. A lot of them use what's called a "two-and-20" fee structure. This means that they charge investors 2% a year just for owning the fund. Then if the hedge fund beats the index it uses as a benchmark, it also take 20% of the value of the outperformance. These layers of fees make it very hard for an investor in a hedge fund to have market-beating returns every year.
Warren Buffett even bet $1 million dollars to back up his belief that the average person should invest in index funds. During the 2006 Berkshire Hathaway annual meeting, Mr. Buffett announced that he was willing to bet that he could pick an investment that would outperform a basket of hedge funds. Not because the fund managers weren't competent, or because of his own investment skill, but because the hedge funds' huge fees handicap them.
Eventually a man named Ted Seides and his fellow hedge fund partners took the bet. They thought they could select a basket of hedge funds that would beat whatever investment Mr. Buffett picked. The wager was for $1 million, with the winner giving the money to charity. The period agreed upon was from Jan. 1, 2008 to Dec. 31, 2017, a total of 10 years.
Mr. Buffett's choice for his side of the wager wasn't some high growth stock that he had spent hours researching. He didn't use some fancy, complex derivative product. He didn't even select shares of his own company, Berkshire Hathaway. He chose an extremely low-cost index fund, the Vanguard 500 Index Fund Admiral Class (VFIAX) - Get Report , as the investment to beat the basket of hedge funds.
He believed that the fees charged by the hedge funds would make it nearly impossible for them to beat the S&P 500 index over a 10-year period.
Things did not start well for Mr. Buffett. As a lot of traumatized investors may recall, 2008 was a terrible year for stock markets. After that first year, the Vanguard index fund was already down 45%. The basket of hedge funds didn't do very well either that year and lost 25%, however. But they still had a 20% lead after only one year, so Mr. Seides and his partners were feeling pretty good.
But the Vanguard index fund beat the hedge funds in 2009. It beat them in 2010 and 2011 as well. Then this basic, inexpensive index fund kept beating the hedge funds again and again.
As of March of this year, the Vanguard index fund was beating the basket of hedge funds by 44%. Since the bet ends at the end of 2017, it looks like Mr. Buffett is going to win.
National Public Radio interviewed Ted Seides in March to discuss the wager. On the program, Mr. Seides admitted that it's not possible to beat the market. When he was asked how most people should invest he gave the best investment advice anyone interested in the stock market will ever hear. He said, "... they should index."
Yes, it's never a good idea to disagree with statistics and Mr. Buffett. You are much better off owning the market by investing in a low-cost index fund or ETF than owning a mutual fund or hedge fund. It's not as exciting to talk about at parties, but it's a strategy that will help you outperform even the smartest stock pickers.
This article is commentary by an independent contributor. At the time of publication, the author held TK positions in the stocks mentioned.