How Index Funds Could Beat Hedge Funds over Time

Upbeat music plays throughout.

Narrator: When the first index mutual fund hit the market in 1976, many professionals in the finance industry lambasted the idea. Because the objective of an index fund is to match the performance of the index it tracks—not outperform the market—critics thought that it meant settling for mediocrity.

Animation: Poster depicts Uncle Sam stamping index funds with the words "un-American." Text says "Help stamp out index funds! Index funds are Unamerican."

Narrator: Some even called the idea "un-American."

In actively managed funds, professionals research, evaluate, and handpick investments.

Animation: Chart compares the hypothetical performance of actively managed funds versus index funds over time.

Narrator: The concept that a passively managed index fund could perform as well as an actively managed fund upended the widely held belief that professional fund managers had a special ability to choose and manage investments to generate excess returns.

Because of their combination of low fees and diversification, index funds began to grow in popularity. However, hedge funds, a type of actively managed investment typically only available to wealthier investors, also grew in prominence over subsequent decades.

Legendary investor Warren Buffett believed that index funds could achieve better returns for long-term investors than actively managed hedge funds. To prove his theory, in 2007, Buffett issued a challenge to the hedge fund industry. He wagered that over the course of 10 years, an unmanaged, low-fee S&P 500^® index fund would outperform hedge funds chosen by a professional.

Buffett expected that a bevy of hedge fund managers would eagerly accept his bet, but he was met with silence.

Finally, a single hedge fund manager accepted the bet and selected five hedge funds to put up against an S&P 500 index fund Buffett chose. The investor whose fund yielded greater returns—minus fees—over the course of 10 years would receive $1,000,000 to the charity of his choice.

During the first year, Buffett's index fund was losing big time.

But the index fund outperformed the hedge funds in the long run.

By year 10, Buffett's index fund returned 7.1% on an average annual basis, whereas the five hedge funds averaged 2.2% annually.

Buffett's index fund was so far ahead of the hedge funds that the manager surrendered months before the 10-year time frame was officially over, and Warren Buffett received $2.2 million to donate to a charity that empowers young women.

Buffett's win suggested that index fund investing doesn't mean settling for mediocrity; it could be an effective strategy for many long-term investors.

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