This article was updated on July 6, 2017, and originally published on Feb. 26, 2017.
In his annual letter to Berkshire Hathaway (BRK.A 0.71%) (BRK.B 0.60%) shareholders, Warren Buffett included an extensive discussion of investment fees, and how they can rob individual investors of profit. Here's what Buffett says most people should do instead, and how you can do it in your own portfolio.
Buffett's $500,000 bet
In Berkshire's 2005 annual report, Buffett said active investment management, as a whole, would underperform the results of simple buy-and-hold investing, over long periods of time.
A few years later, Buffett offered to wager $500,000 that no investment pro could choose a set of at least five hedge funds that would beat the performance of a low-cost S&P 500 index fund of Buffett's choosing, over a 10-year period.
Only one fund manager, Ted Seides, took the bet and chose five "funds of funds" as his picks. The first year tracked for the purposes of the wager was 2008, so 2016 represented the ninth full year. Buffett detailed the year-to-year performance of each investment thus far, and the results aren't even close.
The S&P index fund has returned a compounded average of 7.1% per year -- a total return of 85.4% as of the end of 2016. On the other hand, the collective performance of the five funds-of-funds has been dismal. The total gain of 22% represents just over one-fourth of the return of the S&P index fund. So, barring a miraculous year for the hedge fund industry, it looks as if Buffett and the charity he selected to receive his winnings will be victorious at the end of 2017. In fact, Seides conceded the bet shortly after Berkshire's annual letter discussed the bet's current status.
The best investment most people can make
Buffett's logic is that someone who invests in a S&P 500 index fund, by definition, will match the market's performance.
On the other hand, "active investors" as a group will also deliver average investment performance over time -- that is, some managers' investments will do well, and others won't. However, when you add in the cost of actively managed investment options, particularly hedge funds, the result is that the average hedge fund will underperform the market.
From the results of his bet, which competed against five funds-of-funds that represented hundreds of individual hedge funds, it appears his logic was sound. In fact, Buffett estimates that 60% of all the fund-of-funds gains went toward management fees.
Buffett's main point is that when managers charge high fees, the managers may earn tremendous profits -- but investors won't. Therefore, the best investment most people can make, whether they're wealthy or just have a few hundred dollars to invest, is a low-cost index fund such as the one Buffett used for his bet.
Examples of low-cost index funds
For his bet, Buffett used the Vanguard S&P 500 index fund, which is available in both mutual fund and ETF form. I prefer the Vanguard S&P 500 ETF (VOO -0.33%) for most investors, simply because it's easy to trade and has an extremely low expense ratio (that is, an annual management fee) of just 0.05%. This means if you invest $100,000, your annual expenses will be just $50, so your investment should track the S&P 500's performance very closely.
There are several other S&P 500 index funds in the market that are perfectly fine, and chances are that if you have a 401(k) at work, there's a similar passive investment option. And there are several other types of index funds available that can help you meet your investment objectives.
As one other example, if income is more of a priority for you, the Vanguard High Dividend Yield ETF (VYM 1.16%) could be a good choice for you. The idea behind this index fund is similar to that of the S&P 500 index fund -- large American companies -- but with a focus on stocks that pay relatively high dividend yields. At just 0.08% annually, the cost isn't much more than the S&P 500 version.
As a side note, you may have noticed that I'm a Vanguard fan, as Buffett is, because of the low costs of the company's ETFs and the variety of index fund options available. You can read Vanguard's full ETF list here if you're interested.
Buffett isn't discouraging you from buying individual stocks
To be perfectly clear, Buffett isn't necessarily saying you shouldn't buy individual stocks. If (and this is a big "if") you have the time and desire to properly research companies to invest in, and are committed to building and maintaining a well-diversified portfolio, go for it.
The point is that most investors don't have the time or desire to do all of this, so the other option is fund investing. And simply buying a collection of large American businesses and letting them do the work for you is a far better option than paying hefty fees to some fund manager.