Ordinary stock market investors — you and me, that is, not the big pension funds and other institutions — have two main choices about where to put their money: actively managed mutual funds run by stock pickers claiming to know the magic incantations for finding the best stocks, or passively managed index funds that merely replicate the markets themselves.
Which category performs better? Easy question. It’s index investing, which has smoked the active managers virtually since it was popularized by John Bogle and his Vanguard Group in the mid-1970s.
The latest tally shows that 65% of actively managed U.S. large-capitalization mutual funds fell short of the benchmark S&P 500 stock index in 2024. That’s worse than the 60% of funds that underperformed the benchmark in 2023, and a hair worse than the average rate over the last quarter-century.
Indexing gives you a better chance to ‘be less stupid.’
— Investment advisor Barry Ritholtz
Those dismal statistics come to us via the latest annual SPIVA scorecard (the acronym stands for Standard and Poor’s Index vs. Active). First published in 2002, the scorecard serves as what S&P asserts to be “the de facto scorekeeper of the long-standing active versus passive debate.”
That’s accurate, up to a point. The debate isn’t really about whether index funds perform better than actively managed funds — that debate is essentially over, and indexing wins, hands down. For years, the debate has been more about whether there are aspects of indexing that are bad for the markets, meaning the process of capital allocation.
The virtues of index investing for the ordinary investor are indisputable. As financial planning guru Barry Ritholtz lists them in his forthcoming book “How Not to Invest” (emphasis his), they include, aside from superior long-term performance, lower transaction costs and taxes, simplicity and fewer opportunities for bad behavior through silly mistakes.
It’s common for retail investors to buy high (say, when they catch the euphoria of a market surge) and sell low (say, when they’re rattled by a market downturn), reversing the goal of buying low and selling high.
“Indexing gives you a better chance to ‘be less stupid,’” Ritholtz advises.
The majority of retail investors seem to have taken these points on board. By year-end 2023, according to Morningstar, assets under management at index funds had outpaced those in actively managed funds, $13.29 trillion versus $13.23 trillion. Back in 1993, when Morningstar first began tracking index-versus-active assets, active funds had $1.25 trillion under management, index funds a mere $21 billion.
Before indexing took flight, it was easier to become enthralled by the records of such legendary stock pickers as Warren Buffett, John Templeton and Fidelity’s Peter Lynch, and harder to notice that the vast majority of active managers turned in a few years of outsize returns, but that almost always their performances reverted to the mean, or worse.
Even Lynch’s prowess as a world-beating stock-picker was overstated. From 1977 to 1990, he built Fidelity’s Magellan Fund from $18 million in assets to $14 billion, averaging an annual return of 29%, possibly the most successful such run ever.
But it’s often forgotten that for the first four years of his management, Magellan was a private investment fund for Fidelity’s founding Johnson family. It wasn’t opened to outsiders until 1981.
By the end of Lynch’s run Magellan was a behemoth struggling to eke out “a razor thin margin of victory,” as investment commentator William Bernstein put it. Magellan actually fell behind the S&P 500 in two of Lynch’s final four years of management.
Among all U.S. actively managed stock funds, SPIVA reported last year, fewer than 5% of those that were in the top half one year were “still in that position four years later.”
Those who allowed their brokers to steer them into and out of individual stocks incurred commissions (on both ends of their trades) and taxes, especially on securities that they held for less than a year and therefore couldn’t even claim the lower tax rates on long-term capital gains.
Because index funds buy and sell stocks only when they’re admitted into or dropped from their benchmark index, which happens relatively rarely, they minimize commissions and taxes. They also obviate the emotional component of investing, which so often can lead ordinary investors astray.
The investment method people choose often depends on whether they see investing chiefly as a means to grow wealth or a way to get their gambling jollies as an alternative to going to the closest casino.
Consider this example: Those who invested in a S&P 500 index fund at the beginning of January 2021 and held on through the end of 2024 scored a return averaging 13.6% a year; every dollar they invested grew to $1.67 over that timespan.
By contrast, many of those who piled into the GameStop meme stock frenzy of January 2021 were down by as much as about 90% within days of the stock’s peak, which was nearly $500. If they hung on through the end of 2024, they were still down by more than 60%. In other words, every dollar they invested shrank to less than 40 cents.
That experience evokes a famous observation attributed to economist Paul Samuelson: “Investing should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.”
Success, however, has bred a backlash. As I’ve written in the past, concerns about indexing stretch across the partisan spectrum. Democrats and progressives are uneasy about the concentration of investment power in the hands of a few fund management firms that vacuum the vast bulk of investment dollars into their index funds, notably BlackRock, Vanguard and State Street.
Republicans and conservatives express a narrower concern — they grouse that passive fund managers push a liberal agenda on corporate managements, especially in “ESG” categories, the environment, social issues and corporate governance. Specifically, they’ve been exercised over the managers’ asking their portfolio companies to assess the long-term financial implications of global warming.
These are “political” and “non-financial” goals, 21 red-state attorneys general asserted in a nasty letter to index fund asset managers in March 2023. Never mind that the ramifications of global warming have become only more evident in many of these politicians’ states over the last year or two, or that shareholders of some companies voted to urge their managements to pay attention to exactly these ramifications even before the red states asserted that they were irrelevant to corporate planning.
Other issues related to the concentration of corporate ownership in the hands of a small cadre of fund managers have arisen. The “Big Three” index managers — Vanguard, BlackRock and State Street — combined are the largest shareholder at 96% of the largest 250 publicly traded companies in the United States, according to a 2020 analysis. That study also documented that, “on average, the Big Three control 20.1% of shares at these companies.”
What unnerves investment experts about all this is that index fund investors squeeze passivity to the limit — they don’t take pains to know what companies are actually in their funds’ portfolios or how those individual companies are faring. They just follow how the index is doing.
Another theory holds that the natural dynamic through which shareholders pressure their companies to compete better is destroyed when every major company in an industry is in the same index. In those cases, it’s argued, the index fund managers don’t care for one of their owned companies to compete with others they own in the same field.
Whether that has had the projected effect is uncertain; reams of law-review pages and financial analyses have been filled with conjecture, but it’s hard to nail down the effect.
For all that, it doesn’t seem likely that index fund investing will lose its allure for the investing public any time soon. Investing in individual stocks can be a full-time job, and most people have other full-time jobs. They can outsource their investing choices to active managers who all claim to have a unique skill, or cast their lot with passive managers who follow the indices but almost invariably outperform the stock pickers. Why would anyone act differently?