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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is the author of A Random Walk Down Wall Street
The results are in: this time is not different. Indexing remains the optimal investment strategy.
Every year S&P Global Ratings publishes reports comparing all actively managed investment funds with various stock indices. These reports are considered the gold standard for evaluating the performance of active fund management with their index-fund alternatives.
The bottom line from the year-end 2024 report out this month is that there were no surprises. US passive index funds in 2024 outperformed about two-thirds of actively managed funds. That is consistent with past results that also show that one-third of the managers who outperform in any single year are generally not the same as those who win the comparison in the next.
When you compound the results over 20 years, about 90 per cent of active funds produce inferior returns to low-cost index funds and indexed exchange traded funds. Equivalent long-term results were recorded for funds focused on developed economies, emerging markets and bonds. Even for small-cap funds, which had a good 2024, only 11 per cent outperformed over the past two decades.
It is not impossible to beat the market, but if you try, you are more likely to achieve the returns of the bottom 90 per cent of active managers. The evidence gets stronger every year: index fund investing is an optimal strategy for the ordinary investor.
Despite the evidence, many active managers argue that the future will be different. One common view is that the popularity of passive investing has created an unhealthy concentration of stocks in the popular indices and has made indexing an increasingly risky strategy. A second argument championed by some active managers is that index investors pour money into the market without regard to company earnings and growth opportunities. This compromises the ability of the market to reflect fundamental information, creates mispricing and thus permits active managers to use their skills to outperform in the future.
It is certainly correct that the market is highly concentrated. A few technology stocks (known as the Magnificent 7) have had a one-third weight in the S&P 500 index and were responsible in 2024 for more than half of the market’s 25 per cent total return. But such concentration is not unusual.
In the early 1800s, bank stocks represented about three-quarters of the total stock market value. Railroad stocks constituted much of the total market value in the early 1900s, and internet-related stocks dominated the index in the late 1900s. And it is far from unusual for a small percentage of stocks to be responsible for most of the market’s gains. A study by Hendrick Bessembinder found that only 4 per cent of publicly traded US stocks have accounted for virtually all of the US stock market’s excess returns over Treasury bills since 1926. A concentrated market is not a reason to abandon index funds. Owning all the stocks in the market will ensure that you own the few stocks responsible for most of the market’s gains.
A second “this time is different” argument against indexing is that index funds have grown so fast that it has interfered with the market’s ability to price stocks even nearly correctly and to accurately reflect new information. Some have suggested that the growth of passive indexing has generated stock market bubbles such as the current boom in AI-related stocks. More investing without regard to fundamental information will enable active managers more easily to beat the index in the future.
There are logical and empirical reasons to reject such claims. Even if 99 per cent of investors bought index funds, the remaining 1 per cent would be more than sufficient to ensure that new information got reflected in stock prices.
And if one believes that bubbles will enable active managers to outperform, consider the data for the internet stock boom that expanded until 2000. Many internet-related stocks sold at triple-digit earnings multiples, far higher than the current valuations of today’s favourite AI stocks. SPIVA data shows that during 2001, 2002 and 2003, 65, 68 and 75 per cent of active managers underperformed the market in each of these “post-bubble” years.
The evidence grows more compelling over time. The core of every investment portfolio should be indexed and diversified across asset classes. Indexing will assuredly result in low fees and low transaction costs, and it is tax efficient. Index funds are also boring, and that may be one of their greatest advantages, less vulnerable to the waves of optimism or pessimism that characterise the financial news. As the white rabbit in the film Alice in Wonderland advises us, “Don’t just do something, stand there.”
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