Index Funds - Warren Buffett’s Best Friend
Updated: Mar 18, 2022
The Big Buffett Index Fund Bet
Back in 2007, legendary investor Warren Buffett issued a challenge to the cocky Protégé Partners of the hedge fund industry: he bet he could invest in a passive index fund and, over 10 years, beat any fund Protégé put up against him on a return basis. So today, we’re going to cover what an index fund is, why Buffett picked an index fund as his weapon of choice, and if it’s the right pick for the average investor. At the end, I’ll also tell you if Buffett won his bet. Let’s go!
What Is An Index Fund?
Index funds are a very powerful investment vehicle, and the power is in the name: index. They track an index! But what does that mean, exactly? Well, an index, as covered yesterday in my inflation piece, is a collection of prices grouped into one tracker. An “index fund” is a fund that tracks an index of companies. The most commonly tracked, and purchased, indexes are the Dow, S&P 500 and NASDAQ, most commonly referred to as “the market.” If you watch any amount of CNBC or Bloomberg, you’ll see all three of these referenced every few seconds on the ticker at the bottom. So what does the price of an index mean, exactly?
Related: The Beginner's Guide to Inflation
I’m going to leave out a little bit of complicated math here, but essentially the price of an index is the amalgamation of the prices of the companies within it. The Dow Jones Industrial Average is comprised of 30 companies. Each one of these companies contributes, in percentage terms, to the performance of the index as a whole. That’s what it means when you hear your dad say “the market had a great day today” or “the market crashed so now you can’t go to college.” It means that the companies within that index performed well, or not so well, and contributed to the index as a whole moving in a direction. Same goes for he S&P 500 with its 500 component companies, or the NASDAQ with its 100 components.
Are All Indexes The Same?
Nope! Not even close. Let’s look at the indexes I covered earlier: The Dow, S&P and NASDAQ. The Dow is a more traditional index, and is the oldest. It’s made up of companies like United Health Group, American Express, Boeing, Coca-Cola, Johnson & Johnson and so on. Companies that are more “traditional” in nature. Payment companies, aerospace, banks, legacy technology companies, and even retailers like Nike.
What you won’t find in the Dow average are the high-flying tech companies. Those are found in the NASDAQ, which is made up of companies like Apple, Tesla, Amazon, Advanced Micro Devices (AMD), Netflix, etc. The NASDAQ average has been one of the highest flyers in recent years thanks to its reliance on these tech names, but it’s also the most volatile.
The last one is the S&P 500, and it consists of 500 large-cap companies in the American market that makes up about 80% of the equity market. This includes all of the Dow components and most of the NASDAQ companies. Just like when you’re an athlete and you’re measuring yourself against the world records or the history books, the same goes for investing, and the S&P 500 is that world record. It’s the benchmark against which all funds, fund manager and retail investors measure themselves against. Why?
Why Would I Invest In An Index Fund?
Index funds have three built-in natural advantages:
1. They are naturally diversified
2. They are low-cost
3. They issue dividends to amplify compound interest
Let’s break it down. First, they are naturally diversified. They are the antithesis of “putting all your eggs in one basket,” because you could have 500 different baskets! Let’s say there’s a new health food trend and McDonalds is slow to catch-up. People stop eating there and their share price tanks. But there’s a new iPhone and Apple’s sales race to all-time highs. Though these companies moved in different directions, you didn’t move, because you are invested in both! The power of diversification is that it limits what’s called “the downside risk.” Essentially, it prevents you from basically losing all of your money if a company goes under and their stock drops to 0, because you aren’t solely invested in that company. An investment in an index is an investment in all of the companies within that index, meaning you’re spreading yourself out. Does this mean that you may be capping what your upside is? Sure. But the name of the game here is “wealth preservation,” and you’re accomplishing this quickly and easily.
The next superpower of the index fund is that they are low-cost. Index funds are passively managed, which means Steve the Financial Advisor is not behind his computer actively moving your pennies into and out of companies. Active management requires a human who makes a salary and likely wants to make more money, so they charge commissions. This results in higher costs for you, the investor. Passive funds are derived as a result of the index fundamentally changing, and it’s all taken care of for you, without the help of big Steve. As a result, you are only paying the fund fee, which is much, much lower than an active management cost. Over the life of your investment, this could end up saving you tens of thousands of dollars of your hard, or not so hard, earned money.
The final advantage an index has is that it issues dividends. Not all companies, or funds, issue dividends, so it’s paying you just to hold onto it. And what does that money do? It reinvests itself, if you so choose, and this will amplify the compounding interest effect you see in your total return. For example, Vanguard’s S&P 500 index fund, VOO, pays a 1.81% dividend and historically returns around 10%, inclusive of the dividend. If you invest $10,000 at an 8% return (annual return without dividends), you see that money grow to about $100,000 in 30 years. If you reinvest those dividends and you see the annual return of 10%? That number is now $174,000.
How Do I Pick An Index?
There are honestly two options here: The S&P 500-specific index, or the total market index. You can buy either of these options through literally any brokerage or investment house. Vanguard, Fidelity, Charles Schwab, any of them. If you already have a brokerage account, open it up and look at “Index/ETF’s” and you’ll find any number of them staring you in the face. From there, dig in and do a little research. Some hold higher percentages of a company than others, so check out exactly what you want to find. Want one that holds more Apple? There’s one for that. Want one at equally weighted percentages? There’s one there too. Just one note of warning: watch out for leveraged indexes.
One of the most popular index ETF’s is “QQQ,” which tracks NASDAQ performance. If you look up “TQQQ,” you’ll find what’s called a “leveraged ETF.” These types of funds use derivatives (margin, options, hedges and shorts) in order to amplify the returns of the market. There are leveraged ETF’s that represent 2x or 3x performance. While these sound enticing, they come with extreme risks:
1. Leverage means amplification in both directions. If a standard index were to rise 10% in a year, these leveraged ETF’s would do quite well, up 20 or 30% depending on the one you select. However, if an index is down 10%, then you lost 20 or 30%. Not great.
2. The fees for these are typically extremely high. QQQ’s expense ratio is only 0.20%. TQQQ? 0.95%, almost 5x higher.
I Get It. What Happened to Buffett?
Right! So I mentioned him earlier. Well, Buffett has long been trumpeting the benefits of index funds to the average investor, and was challenged by Protégé Partners to put his money where his mouth was. They each put up $1 million and measure the performance over 10 years. Then, because they’re already super wealthy people, they donate it all to charity. From 2007-2017, here’s how the performance shook out:
Protégé Partners Actively Managed Funds – average annual return of +2.2%
Warren Buffett Passively Managed Index – average annual return of +7.1%
Buffett blew them out of the water, and for the exact reasons I outlined above. Hedge funds take big fees for their active management, whereas passive indexes take small fees for the fund. Buffett also didn’t have to pick and choose stocks during America’s longest bull market run, because he owned them all in a fund! Protégé didn’t have that luxury, and didn’t pick correctly.
These funds eliminate the need to sit there and watch your portfolio. They offer security, growth and even pay you to hold them. They get rid of the human error of stock picking. They are, effectively, the perfect way to grow your wealth. Welcome to the art of the Index Fund.