If you're looking for a great place to stash your retirement savings, then you should consider an investment that Warren Buffett, the greatest investor of our time, wholeheartedly believes in:
What I advise here is essentially identical to certain instructions I've laid out in my will. ... My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors.
Sounds like low-cost index funds are worth investigating -- and the very first of these was the Vanguard 500 Index Fund (NASDAQMUTFUND:VFINX). This passively managed fund that tracks the performance of the S&P 500 was created by index investing pioneer John C. "Jack" Bogle, founder of The Vanguard Group.
Index funds versus actively managed funds
The idea behind mutual funds is that they grant instant diversification. Your money is pooled with that of other investors, and the fund managers then decide what to invest that money in. The theory is that by pooling the resources of lots of investors together, mutual funds can enhance diversification -- and thereby potential returns.
Index funds are passively managed; they simply mirror the holdings of the index they track, so no expert stock-picking is required. Meanwhile, actively managed funds employ fund managers and analysts who seek to find the best stocks to buy. This means that actively managed funds cost more to operate than index funds, but ideally, the professionals should be able to enhance returns -- right?
Yet the data shows us that's just not the case.
Active funds have a high likelihood of underperformance
According to the S&P Dow Jones Indices SPIVA midyear scorecard from July, more than 57.8% of domestic equity (i.e., U.S. stocks) fund managers underperformed their index benchmarks over the prior 12 months. And that's not just a bad year. The percentage of underperformers jumps to 70% when measured over the prior five years.
Even mutual funds that achieve outstanding returns can rarely maintain that outperformance. The S&P Dow Jones Indices persistence scorecard reports that, of the top 25% best-performing funds in the first quarter of 2012, less than 4% were still in the top quartile through the first quarter of 2014. And less than 25% of domestic equity funds managed to stay in the top half by performance over the past three years.
The high cost of fees
The most important number in a mutual fund prospectus is one that many investors overlook: the expense ratio.
The expense ratio is the percentage of the fund's assets that the fund managers charge every year to manage (and sometimes to market) the fund. You'll never see an invoice: The manager simply takes its fee out of the fund's assets. But a fee of 1% or 1.5% sounds like a small amount of money, right?
Wrong. Let me show you how much 1% can cost you:
As you can see, an expense ratio of 1% can have a major impact on your returns. Over 30 years of regular investing, a 1% fee, versus the 0.17% fee of the Vanguard fund, would eat away 18% of your returns. In the example above, someone investing $5,000 per year -- less than $100 per week -- would lose a whopping $76,000 in gains, assuming an annualized return of 8% per year.
The thing is, the example above is conservative with both the historical returns of the S&P 500, and the typical underperformance of managed funds. According to the SPIVA midyear scorecard, the average large-cap fund has actually underperformed the S&P 500 by 1.49 percentage points per year over the past five years. Given that the S&P 500 has returned 11.5% annualized over the past 30 years, here's how much fees and underperformance could have really cost you, on average:
Over the past 30 years, the low-cost Vanguard S&P Index Fund would have outperformed our model mutual fund -- again, based on the actual average underperformance of real funds -- by $198,000. See why Buffett is recommending his estate use this low-cost fund to provide for his heirs?
If it's good enough for Buffett...
Warren Buffett is one of the greatest investors of our time, and he's well aware that few people -- including those who will inherit part of his great wealth -- can duplicate his success. His decision to direct 90% of his wealth (after the gifts to charity) into Jack Bogle's greatest creation makes it pretty clear that many of us should follow suit and avoid actively managed mutual funds.
Jason Hall has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.