In his 2014 annual letter, Warren Buffett outlined instructions he has left for trustees:

"My advice to the trustees 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 – whether pension funds, institutions, or individuals – who employ high-fee managers.”

As with everything else that the Oracle of Omaha proclaims, that piece of advice has been deeply analyzed. In fact, it seems especially pertinent in light of recent market volatility. (See also: 4 Mutual Funds Warren Buffett Would Buy.)

Index funds have grabbed an increasing share of the market for investment products in recent times. While they may be right for Buffett's heirs (who can invest substantial amounts to generate prolific returns), are index funds the correct instruments for lay investors?

What's Wrong With Actively Managed Funds?

The general wisdom is that risk should be commensurate with returns. Thus, if a high-risk investment is successful, then it should translate into handsome returns. Following the same logic, actively-managed funds, which have a high risk profile and employ legions of talented managers (including some aspiring Buffetts), should translate into high returns.

But the upside of actively managed funds can easily turn into losses because they are high risk instruments. This approach does not suit the vast majority of mom-and-pop investors, who put their money away for sustained returns over the long term.

A number of other criticisms have also been leveled against actively-managed funds. For example, they are susceptible to bubbles. In 1993, there were 23 tech focused mutual funds. By 1999, at the height of the dotcom bubble, that number had increased to 93. An additional 82 were launched in 2000. Two-thirds of those funds closed in the subsequent years.

Why Buffett Made The Case For Index Funds?

It is not difficult to guess why Buffett made the case for index funds.

Index funds have a low-risk profile. They mitigate market volatility by spreading risk across multiple asset classes and funds. Because they are passively managed and simply track the performance of an asset class (or an actively-managed fund), their operational costs are low. What's more, their returns average out over a period of time. (See also: Vanguard Index Funds: 4 Reasons They Are Unique.)

A 2013 research paper by Portfolio Solutions and Betterment analyzed a portfolio holding 10 asset classes between 1997 and 2012 and found that index fund portfolios outperformed actively managed portfolios 82% to 90% of the time. The report's authors wrote that the “outcome of this study statistically favors an all-index fund strategy all the time.”

According to the research paper, three factors are responsible for the superior performance of index funds over actively-managed funds: portfolio advantage (they outperform active funds when combined together in a single portfolio), time advantage (they outperformed active funds over longer time durations, ranging from 5 years to 15 years), and active manager diversification disadvantage (index funds outperformed against actively-managed funds holding two or more asset classes).

Last year's Spiva scorecard, which tracks the performance of active funds against their benchmarks, provides numerical evidence of the research. According to the report, 66.11% of large cap managers underperformed the S&P 500. Approximately 57% and 72% of mid cap managers and small cap managers underperformed their respective indexes.

The Bottom Line

Warren Buffett was right in that index funds offer the best value for money during times of volatility. They offer a steady stream of income for the vast majority of investors. However, investors should read the fine print and make sure that the funds are appropriately diversified to withstand turbulence in the markets.

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