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Warren Buffett is wrong about this investment strategy

Warren Buffett
David A. Grogan | CNBC
Warren Buffett

Warren Buffett has wagered $1 million for charity that he can achieve better investment returns than a group of hedge fund managers by simply investing in an S&P 500 passive index fund. That bet will be decided this year, and it looks likely Mr. Buffett will collect.

Mr. Buffett is correct: there are far too many mediocre and expensive funds that shortchange investors. I support his commitment to low cost, simple investments that should be bought and held for the long term. Mr. Buffett's approach of bottom-up investing – rigorously analyzing companies and building a durable portfolio – has proved itself over many decades. And no one's been better at delivering the message that Americans need to save more for retirement -- and to get invested and stay invested.

In his recent annual shareholder letter, Mr. Buffett offers some wisdom based on his years of investing. Let me humbly add my perspective.

First, as is true in many industries, consumers should be wary of product labels. The "active versus passive" debate is an intra-industry argument that does not serve investors. Many mutual funds provide mediocre or poor long-run returns, in part because of high management fees and excessive trading. At the same time, the volatility risks and opportunity costs of passive index investments are typically underestimated or unknown. It's not about active or passive. It's about delivering good long-term investment returns - and low costs are a key component of those returns.

It's also time to challenge the notion that passive index returns are the safe path to a better retirement. Index funds have their place, but they provide no cushion against down markets. Despite trillions of dollars that have flowed into passive investments, only half of the more than 1200 investors we surveyed online last year were aware that index funds expose them to 100 percent of the volatility and losses during market downturns.

"Doing better than the crowd in bad times is one of the most important things an investor can do to grow their nest egg."

Perhaps that's unsurprising given the historic length of this bull market. But markets turn. And doing better than the crowd in bad times is one of the most important things an investor can do to grow their nest egg.

Finally, the elephant in the room. Yes, the average actively managed fund has done worse than the market over meaningful time horizons – but, as Mr. Buffett notes, there are exceptions. An investor who was smart enough to have put $10,000 in the first S&P 500 index fund 40 years ago would have more than a half million dollars today. That said, someone who invested the same amount with the best five active funds from American Funds (The Growth Fund of America, AMCAP, Washington Mutual Investors Fund, The Investment Company of America and American Mutual Fund) would have achieved more wealth.

There's no crystal ball that can tell us before hand which funds will outperform. So, how can investors identify exceptional fund managers? Based on extensive research of thousands of mutual funds over decades, there are actually two simple filters –low expenses and high manager ownership. Tossing out all the high-cost funds and finding fund managers who invest a lot of their own money alongside investors in their fund will result in a select group of fund managers who have consistently outpaced benchmark indexes on average.

Contrary to what some index proponents say, there is nothing random about doing better than the market average over the long term. Like Mr. Buffett, our firm is 86 years old. When we add up the history of our 18 equity funds, they have 653 years of investment experience.

Across that span, in good markets and bad, we have averaged 1.47 percentage points annualized above the relevant index benchmarks - even after all fund expenses.

We are in the midst of the 401(k) generation, with most Americans now in charge of their own retirement. Baby Boomers are retiring by the millions, and younger Americans are worried they won't be able to save enough for their golden years – and they're right. Let's talk about the real steps these investors can take to earn higher returns and peace of mind.

It's a safe bet this is a conversation worth having.

Commentary by Tim Armour, chairman and chief executive officer of Capital Group, home of American Funds and one of the largest investment managers in the world.

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