When Warren Buffett talks, investors should listen -- especially when what he says echoes the sentiments of other investing legends like John Bogle and Burton Malkiel, as well as vast reams of academic research: If you try to pick stocks or mutual funds, you will probably not beat the market, especially after expenses. Therefore, your best bet for the long-term is low cost index funds, which are designed to track the performance of indices, such as the Dow or the Wilshire 5000.
At the Berkshire Hathaway (NYSE: BRK.A) annual meeting, Warren Buffet once again expressed his support for passive investing, saying that "A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money...The gross performance may be reasonably decent, but the fees will eat up a significant percentage of the returns," he said. "You'll pay lots of fees to people who do well, and lots of fees to people who do not do so well." He even conceded that he would be "amazed" if Berkshire Hathaway's portfolio outperforms the S&P 500 by more than few points, given its size.
I agree wholeheartedly with Buffett's ideas. There is simply no reason for most investors to buy actively managed mutual funds. On a governance level, his statement about paying lots of fees to managers who don't perform well may strike at the root of the mutual fund problem: They are compensated for gathering assets, not performing well. Given a choice between staying small and doing well or growing large and doing not so well, the choice is obvious for most fund managers: Grow big because the expense ratio is based on assets under management rather than earnings.
The compensation system makes no sense: Why should someone be paid more for underperforming with 100 million in assets than outperforming with 50 million in assets? But until that changes, mutual funds will continue to focus on asset gathering at the expense of shareholder returns. And that's one good reason to stick with index funds.