Should You Invest In Index Funds? Warren Buffett Thinks So

…9 years ago, Warren Buffett made a $500,000 bet…that a simple index fund would outperform an actively managed hedge fund run by expert investors…[and it did for one or more of the 3 reasons outlined in this insightful article].

Written by DrDrDr

Before you decide, here is some additional information about the fund contenders:

Index funds buy a mix of stocks in a proportion that represents the overall stock market or a particular market segment. Index funds are typically managed automatically by a computer algorithm, and management fees for this type of fund are usually very small — around 0.1% or sometimes even lower.

Hedge funds put money into alternative investments that can go up if the stock market goes down. Of course, hedge funds also try to provide maximum returns and beat the stock market if possible. Hedge funds may invest in real estate, commodities, business ventures, and other opportunities that fund managers think will hedge against potential stock market losses and produce good returns. These funds are actively managed and have high management fees of around 2% or more.

Buffett picked a simple S&P 500 index fund for the wager. He bet against an investment manager who picked a set of five hedge fund portfolios. After letting these investments play out for nine years, Buffett announced the results of this wager in the chairman’s letter in this year’s annual report for the holding company he controls and runs, Berkshire Hathaway: The index fund outperformed the actively managed funds…[and] Buffet’s experience mimics numerous studies that have shown that index funds consistently beat the results of actively managed funds.

Why does a simple and essentially automatic investment strategy (the index fund) outperform sophisticated investment funds managed by active expert investors?

1. Low fees

Fund fees, also known as expense ratios, are much lower for index funds than for actively managed hedge funds or mutual funds. You can find index funds with fees under 0.1%, while actively managed hedge funds can have fees of 2% or more.