For all of his investing prowess, it’s illuminating to hear the positive opinion of Warren Buffett on Index Funds. But there is sound reasoning behind the Berkshire Hathaway CEO’s endorsement of these products.
In a dramatic illustration of his point of view, Buffett made a bet in 2007 with some hedge-fund managers that the Vanguard 500 Index Fund could beat the combined performance of a collection of hedge funds over the ensuing 10-year period. The result was that the hedge funds only returned 2.2% compounded annually while the index fund returned 7.1% compounded annually – a total return of over 80%.
Index funds include those that track an index, such as the Standard & Poor’s 500 Index. The fund managers tend to buy and hold stock positions for a long time and are not active managers as in other types of mutual funds, where the managers pick their own stocks. This means index funds have generally lower fees, including their expense ratios. In contrast, hedge funds have highly-paid money managers and they are often structured with an annual expense of 2% of assets under management plus additional hefty annual fees if the fund exceeds performance thresholds. Fund expense ratios vary across the board but many actively-managed mutual funds typically have expense ratios of around 1.0% to 1.5%. Index funds are usually much lower.
Fees and expenses can really affect the rate of return an investor earns over time. To quote Buffett, “Costs really matter in investments. If returns are going to be seven or eight percent and you’re paying one percent for fees, that makes an enormous difference in how much money you’re going to have in retirement.”
In an ironic twist, it appears that many of Berkshire Hathaway’s subsidiaries do not have retirement plans that have access to low commission/low fee index funds, according to a recent ProPublica report. Based on Buffett’s hearty recommendation of these products to investors, it will be a good day when that situation is corrected.