Why passive investing is better for almost everyone saving for retirement

Investing in market-tracking index mutual funds, known as passive investing, is considered boring.

But the truth is in the returns: index funds routinely host funds actively managed by professional stock pickers.

Last year was no exception, according to a new report from BofA Global Research. Professionally managed funds outperformed passive indexes that track U.S. large-cap stocks.

Only 36% of actively managed US large-cap mutual funds, for example, had gains greater than their Russell 1000 benchmarks by 2024.

The Russell 1000, a stock index that gives exposure to companies like Apple, Nvidia, Microsoft, Amazon and Facebook parent Meta, had a lot of strength behind these tech stocks, to be fair.

But it’s no coincidence. Among the more than 1,900 US mutual funds and ETFs tracked by Morningstar, 19% beat the S&P 500, which returned 25%, and only 37% beat their category index in 2024.

For two decades, S&P Dow Jones Indices has been producing “dashboards” that compare the performance of actively managed fixed income and equity mutual funds against various indexes over different time periods. Over the past three years, for example, 86% of actively managed funds failed to match the S&P 500. Over a 10-year period, 85% of these funds under performance the S&P 500, according to the data.

A superstar admirer of low-cost index funds is Warren Buffett.

“In my view, for most people, the best thing to do is to own the S&P 500 index fund,” Buffett said in a Berkshire Hathaway Annual Meeting of Stockholders a few years ago

“People will try to sell you other things because there’s more money in it for them if they do. And I’m not saying that’s a conscious act on their part. Most good salespeople believe their own craziness…that’s why I suggest .to people who buy an index fund.”

Berkshire Hathaway CEO Warren Buffett tours the exhibit hall at the company's annual meeting in Omaha, Nebraska, April 29, 2022. REUTERS/Scott Morgan — Berkshire Hathaway CEO Warren Buffett tours the exhibit hall at the company’s annual meeting in Omaha, Nebraska, April 29, 2022. REUTERS/Scott Morgan · REUTERS / Reuters

I’m a big fan of investing my retirement savings in index funds because it’s simple and less expensive than buying individual stocks and bonds to buy and sell at the perfect time.

And chances are you’ll get out the slides in the stock market if the course is maintained in diversified baskets of shares and bonds.

Sure, it’s more like a smooth teacup spin at Disney World’s Mad Tea Party than Six Flags’ Maxx Force, but for most of us, it’s the ticket to ride.

Investors who choose actively managed mutual funds tend to pay higher fees than passive investors, which is a disadvantage because of the yield imbalance.

It’s also perfectly fine to say that investing in index funds is passive, since the point of owning them is for you to cool your jets when the markets go bad.

Investing in index funds, balanced between stocks, such as the S&P 500 index, and fixed-income bond funds, put on autopilot, has been classic advice for many investors, especially those who are pulling out of funds of retirement And if you’re already retired, cost management helps increase take-home returns.

“I anchor clients’ investments in a passive index strategy because history continues to show that passive investments outperform active managers over a long period of time,” Lazetta Rainey Braxton, financial planner and founder of The Real Wealth Coteriehe told Yahoo Finance. “Objectives are being consistently achieved in investing without the added risk of trying to track and follow active managers who can get that extra return after their fees.”

While fees have been falling in recent years, in 2023 equity index mutual funds had an average asset-weighted expense ratio of 0.05%, according to research by the Investment Company Institute (ICI), compared to .42% of actively managed equity investment funds.

Index funds are all the rage these days. About 52.6% of mutual fund and ETF assets were in passive funds at the end of November, compared with 49.6% in November 2023, according to research and consulting firm Cerulli Associates.

One of the big drivers of the shift to index funds: an increase in investment in target date funds.

I’m guessing many of you are already investing in index funds in your employer-provided retirement plans, such as your 401(k). Virtually all 401(k) plan sponsors and most state self-IRA programs use target date funds when they automatically enroll workers in a retirement plan.

These funds are usually made up of index funds.

With a target date retirement fund, you select the year you want to retire and buy a mutual fund with that year in its name (such as Target 2044). The fund manager then splits your investment between stocks and bonds, adjusting to a more conservative mix as the target date approaches.

At Vanguard, for example, 83% of 401(k) participants used target-date funds and 70% of target-date investors had their entire account invested in a single target-date fund. That’s up from 6 in 10 by 2022, and more than double the number in 2013, according to Vanguard.

"The passive approach has proven to work," Zaneilia Harris, financial planner and president of Harris & Harris Wealth Management Group, told Yahoo Finance. (Photo courtesy of Zaneilia Harris) — “The passive approach has been proven to work,” Zaneilia Harris, financial planner and president of Harris & Harris Wealth Management Group, told Yahoo Finance. (Photo courtesy of Zaneilia Harris)

I reached out to financial advisors to learn about the role index funds should play in retirement accounts. Here’s why they love them too:

“The passive approach has been proven to work because of consistency, increasing contributions, time and compound interest,” said Zaneilia Harris, financial planner and president of Harris & Harris Wealth Management Group. on Yahoo Finance.

“John Bogle, the grandfather of passive investing, promoted it to be simple, easy and profitable,” he said.

But he also advises his customers to add some juice. “Some investors may take a more strategic approach to growing their retirement savings, such as adding a handful of individual stocks,” Harris said.

For Leo Chubinishvili, financial planner at Access Wealth, it’s all about those underlying fees. “Cost efficiency: Passive funds, like index funds, have lower expense ratios compared to actively managed funds,” he told Yahoo Finance. “Cost savings add up over time, benefiting retirement savers. And passive investments could minimize the temptation to make frequent adjustments based on market volatility.”

Cheerful senior couple having fun while riding roller coaster in amusement park. copy space — (Getty Creative) · Skynesher via Getty Images

For today’s retirees, index funds make sense for a few key reasons, Morningstar’s Christine Benz director of personal financehe told Yahoo Finance

“Building a streamlined investment portfolio is important at any age, but it’s especially beneficial as we age. Index funds give you broad market exposure in a simple package. You don’t have to worry about management changes or portfolio with broad market index funds, and it’s also easy to see if rebalancing is in order and where to do it.”

He added: “Reducing the moving parts of your portfolio makes life easier for your loved ones if they need to manage your finances at any time.”

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The tax benefits are another big reason why they are attractive to retirees. Index fund portfolios (especially ETF portfolios) tend to have low tax costs, especially for stocks, Benz said.

“Since many investors’ portfolios are at their peak at retirement and include a significant portion of taxable and non-retirement assets, reducing tax drag is another way to increase returns” , he said.

One caveat: “Passive management is cheaper than active management and works very well in a bull market,” said Cary Carbonaro, managing advisor at Ashton Thomas. “It’s in a bear market where it might not do so well.”

Kerry Hannon is a senior columnist at Yahoo Finance. She is a career and retirement strategist, and the author of 14 books, including “In Control Over 50: How to Succeed in the New World of Work” and “Never too old to get rich.” follow her blue sky

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