Personal Finance

Active fund managers rarely beat their benchmarks year after year

Buffett: Pros won't get a better result than index funds
Buffett: Pros won't get a better result than index funds

For ordinary investors, Warren Buffett recommends they own an index fund.

"It will do better on balance than what they will get if they go to professionals," Buffett told CNBC's "Squawk Box" on Monday. "Because the professionals, after fees, don't know how to get a better result."

New research from S&P Dow Jones Indices backs up Buffett's point. Analysts found that active fund managers who outperform their benchmark in one year struggle to get similar gains in the following years.

"If you have an active manager who beats the index one year, the chance is less than a coin flip that the manager will beat the index again next year," said Ryan Poirier, senior analyst at S&P Dow Jones Indices who co-authored the report.

Poirier and his colleague tracked a group of funds that outperformed the benchmark based on three-year annualized returns, net of fees. The researchers then examined whether these "winning" funds could continue to beat their benchmarks during each of the subsequent three years. They studied fund performance from March 2000 through September 2016.

The results were bleak for professional stock pickers. Only 5 percent of mutual funds that invest in large U.S. companies that had a winning three-year record against the S&P 500 continued to beat their benchmark in the three following years. (See table below.)

The research shows that investors are not served well by chasing managers with great three-year track records, Poirier said.

Buffett's praise of indexing and more evidence about how difficult it is for the average investor to find a market-beating stock fund may continue to drive more people to index funds.

What is missing in the debate about the value of active funds and index funds is how much management fees affect returns, said Alex Bryan, Morningstar's director of passive strategies research.

"It's not really active versus passive, it's more high-cost versus low-cost funds," Bryan said.

The Oracle of Omaha made a similar point in his latest annual letter to Berkshire Hathaway shareholders: "As Gordon Gekko might have put it: 'Fees never sleep.'"