Why Warren Buffett recommends low-cost index funds

Warren Buffett became one of the world's most successful investors by choosing individual businesses. His advice to most investors is not to imitate him. In Berkshire Hathaway's 1996 shareholder letter, he wrote: "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees."

That recommendation is not a stray quotation. Buffett has made the same case for decades. It has three parts: own a broad collection of businesses, admit when you cannot identify future winners, and keep as much of the return as possible.

You do not need to pick the winning company

Buffett's own portfolio is concentrated because he believes he can evaluate businesses. In his 1993 shareholder letter, he drew a different path for an investor who cannot. That investor should own many companies, spread purchases over time, and buy an index fund periodically. His memorable conclusion was that when "dumb" money recognizes its limitations, it stops being dumb.

An index fund does not need to know which company will dominate the next decade. It follows rules that give an investor a share of a market. The guide to how index investing works explains how those rules turn an index into an investable fund.

This is the first reason Buffett's advice is difficult to beat. It removes a prediction that most people are not equipped to make. You no longer need to select the winning company or the manager who will select it for you.

Every fee comes out of the investor's return

The second reason is arithmetic. Investors collectively own the businesses in a market and receive the returns those businesses produce. Brokers, fund managers, consultants and advisers can divide that return differently, but their fees cannot create more of it.

Buffett illustrated the point in his 2005 shareholder letter with the fictional Gotrocks family. The family collectively owned every American business. A growing cast of helpers persuaded family members to trade with one another, then charged commissions, management fees, consulting fees and performance fees. The businesses produced the same earnings, but the family kept less.

His conclusion was blunt: "For investors as a whole, returns decrease as motion increases."

The Canadian Investment Regulatory Organization lists the same kinds of deductions in more practical terms. Fund expenses, trading commissions, bid-ask spreads, account charges, advice fees and foreign-exchange costs can all reduce what an investor keeps. A low-cost index fund avoids the expense of paying a manager to search for winners, but its own costs still need to be checked.

The famous 90/10 instruction was personal

Buffett became more specific in his 2013 shareholder letter. He wrote that a non-professional investor should own a cross-section of businesses through a low-cost S&P 500 index fund, accumulate over a long period and avoid selling because of bad news.

The same letter disclosed instructions for money left in trust for his wife: 10% in short-term U.S. government bonds and 90% in a very low-cost S&P 500 index fund. That is an estate instruction for one wealthy American household, not a universal asset allocation.

A Canadian investor still has to choose an asset allocation that fits the goal, time horizon and ability to live through losses. The S&P 500 holds large U.S. companies. It does not by itself provide Canadian stocks, international markets outside the United States, or bonds. The Ontario Securities Commission's investor education site explains that diversification can cross asset classes, industries and countries.

The lesson to copy is broader than the ticker Buffett named: decide what markets and asset classes the portfolio should own, use diversified funds to own them, and then keep costs low.

What to copy from Buffett

Before treating a fund as the Buffett choice, check four things:

• Does it hold a broad collection of investments rather than one company, industry or theme?
• Does its mix of stocks and bonds fit when the money will be needed?
• What will it cost to own and trade, including fund and account costs?
• Can you keep holding it when markets fall and the news is frightening?

Buffett's decade-long wager against five portfolios of hedge funds supplied a neat final line. When the result appeared in Berkshire's 2017 shareholder letter, the low-cost S&P 500 fund had gained 125.8%. Every competing portfolio finished behind it. One wager does not prove that every active manager will lose, and Buffett acknowledged that some skilled managers can outperform. It does show how costs and a difficult manager-selection decision can work against the investor. Buffett summarized the durable part in six words: "Performance comes, performance goes. Fees never falter."

Low cost does not rescue the wrong portfolio. But when two diversified funds do the same job equally well, the cheaper one leaves more of the return with you. That is the Buffett advice worth copying.