Access to the Editor’s Digest is currently free. Roula Khalaf, the Editor of the Financial Times, selects her favorite stories for inclusion in this weekly newsletter.
The author of “A Random Walk Down Wall Street” reports that the conclusion remains: Indexing continues to be the most effective investment strategy. Annually, S&P Global Ratings releases reports comparing all actively managed investment funds against various stock indices. These reports serve as the gold standard for assessing the performance of active fund management relative to index-fund alternatives.
The final statement from the year-end 2024 report, which was released this month, indicates that there were no unexpected results. In 2024, U.S. passive index funds outperformed roughly two-thirds of actively managed funds, aligning with previous findings that demonstrate that those who outperform in any given year often do not repeat this success in subsequent years. Over a 20-year span, approximately 90% of active funds yielded returns below those of low-cost index funds and indexed exchange traded funds. Similar long-term outcomes were observed for funds concentrated on developed economies, emerging markets, and bonds. Even small-cap funds, which performed well in 2024, only saw 11% outperform over the past two decades.
Though beating the market is not impossible, attempting to do so generally places one amongst the lower 90% of active managers in terms of returns. Each year adds more evidence that index fund investing is the optimal route for the average investor.
Despite consistent findings, many active managers contend that future conditions will diverge. One prevalent belief is that the growth of passive investing has led to an unhealthy concentration of stocks in major indices, thereby increasing the risk associated with indexing. A second argument made by some managers is that index investors contribute capital to the market without considering company earnings and growth prospects. This may inhibit the market’s ability to accurately reflect fundamental information and create mispricing situations, potentially allowing skilled active managers to achieve superior performance in the future.
It is valid to say that the market is significantly concentrated. A select group of technology stocks, often referred to as the “Magnificent 7,” had a one-third weighting in the S&P 500 index and were responsible for more than half of the market’s 25% total return in 2024. However, such concentration is not uncommon. In the early 1800s, bank stocks comprised about three-quarters of total stock market value. Railroad stocks dominated the market in the early 1900s, and later in the 20th century, internet-related stocks influenced the index heavily. It is also common for a small percentage of stocks to account for the majority of market gains. Research by Hendrick Bessembinder has shown that only 4% of publicly traded U.S. stocks have contributed to virtually all of the U.S. stock market’s excess returns over Treasury bills since 1926. A concentrated market does not provide a rationale to forgo index funds; owning a broad selection of stocks ensures ownership of those contributing to most market gains.
Another argument against index funds suggests that their rapid growth has disrupted the market’s ability to price stocks accurately and reflect new information. This line of thought implicates passive indexing in stock market bubbles, such as the recent boom in AI-related stocks, and suggests it enables active managers to surpass index performance in the future.
There are both logical and empirical reasons to dismiss these claims. Even if 99% of investors purchased index funds, the remaining 1% would be sufficient to ensure that new information is incorporated into stock prices. For those who believe bubbles allow active managers to excel, data from the internet stock boom ending in 2000 is pertinent. During the subsequent “post-bubble” years of 2001, 2002, and 2003, SPIVA data showed that 65%, 68%, and 75% of active managers, respectively, underperformed the market.
The evidence for index investing grows more compelling with time. The foundation of any investment portfolio should consist of indexed assets that are diversified across various classes. Indexing guarantees low fees, low transaction costs, and tax efficiency. Index funds are often perceived as lackluster, yet their lack of susceptibility to market fluctuations may be one of their greatest strengths. As the White Rabbit in “Alice in Wonderland” suggests, “Don’t just do something, stand there.”