“By periodically investing in an index fund, the know-nothing investors
can actually outperform most investment professionals.”
— Warren Buffett

The debate about active management and index investing has raged for decades. Money managers tout the potential of “beating the market” while index funds simply deliver market returns less a very small fee.

Both take market risk-but index funds eliminate the risks of individual stocks, market sectors and manager selection.

While pushback from many investment providers may not like this column, famous investors including Warren Buffett, Charles Schwab, Peter Lynch, Jack Bogle and so many others agree that a low-cost index fund is the way to go for a great majority of investors — and I agree.

Let’s look at why.

Take U.S. large company stocks as an example, using the S&P 500 as the benchmark. With an S&P 500 index fund, you automatically own all 500 stocks based on their market capitalization!

Your index fund will track the index returns, less a small fee — likely under lObp (ten one-hundreds of 1%).

The index is rebalanced quarterly by Standard & Poors, so it continues to reflect the market. By contrast, active managers decide which stocks to buy and sell-and in what proportion.

To be considered a “diversified” mutual fund, managers must be broadly invested across multiple market sectors, assets and/or geographic regions.

According to Fidelity, most mutual funds hold well more than 100 securities. The hope is that a manager’s stock-picking skills (stock selection) will result in higher returns than the overall market. But is this hope actually realized?

First, consider that fact that only half of any group involved in any activity will be better-than-average­ with the other half being worse-than-average.

So, at most only half of active managers could beat the market in any given time period.

But now you need to deduct the fees that managers charge from gross returns — which means less than half will beat the index.

According to the industry’s own Investment Company Institute, the average expense ratio for actively managed stock mutual funds is 68bp (about two-thirds of 1%).

While this expense ratio has dropped sharply from a quarter-century ago, it is still about 6-10 times higher than most index funds.

Trading costs and taxes can take an additional bite out of returns. Suffice it to say that active managers must overcome a sizable hurdle to even equal market returns, much less beat the market.

Beating the market in any given year is challenging — but each year some managers do. Morningstar reported that 57% of active managers’ funds beat index peers in the 12 months ending June 23.

But what are the odds of beating the market over longer time periods? Answer: not good.

Morningstar noted that for the 10 years ending June 2023, just one out of every four active funds beat their index rivals.

This can vary by asset class, so let’s continue looking at the “U.S. large blend” category (like the S&P 500).

For time periods ending June 30, 2023, 50.4% of active funds beat the index. But just 29.5% did so over five years — and just 9.8% did so over 10 years.

Results for lower-cost funds did slightly better­, with 16.2% beating the index over 10 years.

And keep in mind, these statistics are a bit “stacked” because they do not include funds that did not survive.

These odds make Las Vegas seem good.

But the challenge gets even more complicated because you need to choose the fund before you know if the manager will be one of the relatively few winners over the next five to 10 years.

In the 1970s, Paul Samuelson (Nobel Prize winner in economics) noted that while it’s possible to beat index funds, it isn’t worthwhile for most of us to try.

Yet the desire to “beat the market” can be powerful. The most frequently used method to choose an active manager is to look at their track record. Note that regulators require a warning label saying “past performance is no guarantee of future results” — yet that is precisely what you are doing by comparing track records.

On Dec. 2, 2022, The New York Times featured an article about an S&P Dow Jones team that looked at all 2,132 broad, actively managed domestic stock mutual funds that had been operating for at least 12 months as of June 2018.

Guess how many of those funds remained in the top quarter for the four succeeding 12-month periods through June 2022? The answer was NONE.

Not even one of the initial 2,132 funds managed to achieve top-quartile performance for the five successive years.

I found this very timely example in an April 24 Wall Street Journal article, “Cathie Wood’s Popular ARK Funds Are Sinking Fast.”

The ARK Innovation Fund and manager Cathie Wood were media darlings in 2020 and 2021 as the fund saw stellar returns and huge cash inflows. The fund is heavily concentrated in a handful of stocks — with just seven stocks making up about half the fund.

Returns have been very volatile since its 2014 inception — but especially so in recent years. ARKK was up 152.51% in 2020 — and guess what? According to Morningstar, ARKs biggest inflows came in the months surrounding the the innovation fund’s February peak.

It was unfortunate timing for many investors as the fund tumbled 23.26% in 2021 and was down another 66.99% in 2022.

The Wall Street Journal article went on to say, “By the end of last year, ARK funds had destroyed more wealth than any other asset manager over the previous decade, losing investors a collective $14.3 billion.”

Diversification, simplicity, low cost and tax efficiency are compelling arguments for using index funds.

Some investors may want to use a “core and satellite” approach with index funds serving as the core of a portfolio with a few more “adventuresome,” actively managed funds around the core.

Options for the “satellite,” which might equal 10% to 20% of the overall portfolio, might include emerging market funds, sector/specialty funds, and nondiversified funds that make “big bets” with a small number of holdings.

Keep in mind that these kinds of funds involve greater risk — which may or may not pay off. But you could just keep it simple with a portfolio of domestic and international stock and bond funds with the stock/bond mix consistent with your financial goals, time horizon and risk tolerance.

In my next column, we’ll talk about taxes — so stay tuned.