The astonishing $216 billion that flowed into the Vanguard Group last year is just the latest endorsement of index funds over actively managed mutual funds.
Investors have been moving toward index funds for years, helped in part by research showing that broad market benchmarks like the S&P 500 tend to outperform actively managed accounts.
The S&P Composite 1500, for instance, averaged a 16.4% annual return over the previous three years, beating domestic funds, which had average returns of 14.4%, according to a 2014 McGraw-Hill study. The comparison gets even worse when you include investors trading individual stocks as well as funds. A 20-year study ending in 2011 found that they earned 2.5% annually vs. 7.8% for the S&P 500.
Last year, it was worse than most too. The median investor earned just 4.2%, compared with 14.2% for the S&P 500 index, with dividends reinvested.
Even against a relatively moderate passive fund they lose out: The Vanguard Balanced (60/40) Index Fund Admiral Shares (VBIAX) - Get Report earned 9% last year and, it might be noted, edged the S&P 500 stock index 52% to 51% over its 14-year history. If anything, the case for passive investing has gotten stronger. The increasing inflow to index funds has enabled index fund managers to lower their expense ratios faster than active managers, increasing the return to index fund investors. Actively managed equity funds have an average expense ratio of 0.89%, while it is only 0.12% for equity funds and as low as 0.05% for S&P 500 index funds.
There are, of course, stock pickers who beat the overall market. But very few do it consistently. Last year, for instance, three-quarters of active managers failed to beat their benchmark.
It's telling that one stock picker who consistently beats the market, Warren Buffett, has said he will leave behind 90% whatever money he hasn't already given away in an S&P 500 fund, not in Berkshire Hathaway stock (BRK.A) - Get Report . He even has a specific fund in mind: Vanguard's S&P 500 Stock Index Admiral Fund (VFIAX) - Get Report .
The single choice is significant. He's not investing in a portfolio of index funds. That would constitute a fairly active investment strategy, but a single index fund that represents the market and stock investing as a whole.
Still, investing in the VFIAX is not an entirely passive choice. It's a vote in favor of large cap stocks. A truly unbiased investment would be a total market mutual fund or, perhaps, even an ETF, like Vanguard's Total Market ETF (VTI) - Get Report . Its expense ratio is a mere 0.05% and has led the S&P 500 by the nose for 14 years, gaining 83% vs. 63%.
Active managing is, therefore, also being done when an investor chooses small cap funds, like Vanguard's Small-Cap Index Fund (VB) - Get Report . But the returns have been far superior to VTI throughout its 10-year existence: 136% vs. 82%.
Investors seeking the widely recommended diversity delivered by foreign stocks could save some money for an international market index fund, like Vanguard's Total International Stock ETF (VXUS) - Get Report , though it has lost 3% during the four years it has been trading.
Still, one size doesn't fit all. The perfect stock portfolio varies depending on the investor's needs, goals and tolerance for risk. It makes a lot more sense, for example, for a young aggressive investor to seek higher returns picking stocks than an older conservative investor.
Also, some types of equities, like emerging markets and small caps, tend to offer greater rewards, as well as risks. They may make a significant part of the equity portfolio too, perhaps a third. Naturally, there are index funds for emerging markets as well -- like Vanguard's Emerging Markets Stock Index Fund (VWO) - Get Report , which gained 60% over the past decade.
This article is commentary by an independent contributor. At the time of publication, the author owned shares of Vanguard's S&P 500 Stock Index Admiral Fund.