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Investing in market-tracking index mutual funds, known as passive investing, gets brandished as boring.
But the truth is in the returns: Index funds routinely clobber funds actively managed by professional stock pickers.
Last year was no exception, according to a new BofA Global Research report. Funds run by the pros had a heck of a time beating the returns of passive indexes that track US large-cap equities.
Just 36% of actively managed US large-cap mutual funds, for example, delivered bigger gains than their Russell 1000 index benchmarks in 2024.
The Russell 1000, an equities index that provides exposure to companies such as Apple, Nvidia, Microsoft, Amazon, and Facebook parent Meta, had lots of oomph behind it with these hot tech stocks, to be fair.
But it’s no fluke. Among over 1,900 US equity mutual funds and ETFs tracked by Morningstar, 19% beat the S&P 500, which had a 25% return, and only 37% beat their category index in 2024.
For two decades, S&P Dow Jones Indices has been producing “scorecards” that compare the performance of actively managed equity and fixed-income mutual funds with various indexes over different time spans. In the last three years, for instance, 86% of actively managed funds couldn’t match the S&P 500. Over a 10-year period, 85% of these funds underperformed the S&P 500, according to the data.
One superstar admirer of low-fee index funds is Warren Buffett.
“People will try and sell you other things because there’s more money in it for them if they do. And I’m not saying that that’s a conscious act on their part. Most good salespeople believe their own baloney…that’s why I suggest to people they buy an index fund.”
Berkshire Hathaway CEO Warren Buffett rides through the exhibition hall at the company’s annual meeting in Omaha, Nebraska, on April 29, 2022. REUTERS/Scott Morgan ·REUTERS / Reuters
I’m a fervent fan of investing my retirement savings in index funds because it’s simple and less expensive than cherry-picking individual stocks and bonds to buy and sell at the perfect time.
if you stay the course in diversified baskets of stocks and bonds.
Sure, it’s more like taking a gentle tea cup spin at Disney World’s Mad Tea Party than Six Flags’ Maxx Force, but for most of us, it’s the ticket to ride.
Investors who choose actively managed mutual funds typically pay higher fees than passive investors, which is a headscratcher given the performance imbalance.
Calling investing in index funds passive is perfect, too, since the aim of owning them is for you to cool your jets when markets get mucky.
Investing in index funds — balanced across stocks, such as the S&P 500 index, and fixed-income bond funds and put on auto-pilot — has been classic advice for many investors, particularly those socking away retirement funds. 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,” Lazetta Rainey Braxton, a financial planner and founder of The Real Wealth Coterie, told Yahoo Finance. “Goals are being met consistently investment-wise without the additional risk of trying to track and follow active managers who can squeak out that extra return after their fees.”
While fees have been falling in recent years, in 2023 index equity mutual funds had an asset-weighted average expense ratio of .05%, according to research by the Investment Company Institute (ICI), compared to .42% for actively managed equity mutual funds.
Index funds are in vogue these days. Some 52.6% of mutual fund and ETF assets were in passive funds as of the end of November, compared to 49.6% in November 2023, according to research and consulting firm Cerulli Associates.
One big driver of the move into index funds: an upsurge in target-date fund investing.
My guess is many of you are already investing in index funds in your employer-provided retirement plans such as your 401(k). Virtually all 401(k) plan sponsors and the majority of state auto-IRA programs use target-date funds when they automatically enroll workers in a retirement plan.
These funds are typically made up of index funds.
With a target-date retirement fund, you select the year you’d like to retire and buy a mutual fund with that year in its name (like Target 2044). The fund manager then splits your investment between stocks and bonds, tweaking that to a more conservative mix as the target date nears.
At Vanguard, for instance, 83% of 401(k) participants used target-date funds, and 70% of target-date investors had their entire account invested in a single target-date fund. That’s up from 6 in 10 in 2022, and more than double the figure in 2013, according to Vanguard.
“The passive approach has proven to work,” Zaneilia Harris, a financial planner and president of Harris & Harris Wealth Management Group, told Yahoo Finance. (Photo courtesy of Zaneilia Harris)
I reached out to financial advisers to get their take on the role index funds should play in retiree accounts. Here’s why they love them, too:
“The passive approach has been proven to work because of consistency, increasing contributions, time, and compound interest,” Zaneilia Harris, a financial planner and president of Harris & Harris Wealth Management Group, told Yahoo Finance.
“John Bogle, the grandfather of passive investing, promoted keeping it simple, easy, and cost-efficient,” 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, like adding a handful of individual stocks,” Harris said.
For Leo Chubinishvili, a financial planner at Access Wealth, it’s all about those nitty-gritty underlying fees. “Cost efficiency — passive funds, such as index funds, have lower expense ratios compared to actively managed funds,” he told Yahoo Finance. “Cost saving compounds over time, benefiting retirement savers. And passive investments might minimize the temptation to make frequent adjustments based on market volatility.”
Sure, it’s more like taking a gentle tea cup spin at Disney World’s Mad Tea Party than Six Flags’ Maxx Force, but for most of us, passive investing is the ticket to ride. (Getty Creative) ·skynesher via Getty Images
For current retirees, index funds make a world of sense for a few key reasons, Christine Benz, Morningstar’s director of personal finance, told Yahoo Finance
“Running a streamlined investment portfolio is important at any age, but it’s particularly beneficial as we age. Index funds provide you with broad market exposure in a simple package. You won’t have to worry about management changes or portfolio changes with broad-market index funds, and it’s also a cinch to see whether rebalancing is in order and where to do it.”
She added, “reducing the moving parts in your portfolio makes life simpler for your loved ones if they need to manage your finances at any point in time.”
The tax benefits are another big reason these have appeal for retirees. Index-fund portfolios (especially ETF portfolios) tend to have low tax costs, especially on the stock side, Benz said.
“Given that many investors’ portfolios are at their high-water mark at retirement, and include a significant share of taxable, non-retirement assets, reducing the drag of taxes is another way to increase take-home returns,” she said.
One caveat: “Passive is cheaper than active management and it does very well in a bull market,” said Cary Carbonaro, managing adviser at Ashton Thomas. “It is in a bear market where it might not do as well.”
