Warren Buffett recommends index funds for investors — but hardly invests in any himself. How come? Here's why they might not be suitable for everyone (2024)

Index funds have become massively popular in recent years. Even investing icon Warren Buffett has sung their praises.

So why does his holding company, Berkshire Hathaway, only have a miniscule amount invested in them?

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An index fund is a mutual fund or exchange-traded fund (ETF) that tracks the performance of a specific market index, such as the S&P 500. The fund includes a representative sample of stocks or bonds from the index it tracks, as opposed to hand-selecting them. They’re typically less expensive to invest in than actively managed mutual funds.

Buffett has previously demonstrated his firm belief that low-cost index funds can outperform hedge fund managers in the long term. In his 2013 letter to Berkshire Hathaway shareholders, he revealed that, upon his death, the trustee of his wife’s inheritance has been instructed to put 90% of the money into a low-fee stock index and the remainder into short-term government bonds.

Yet, Berkshire Hathaway’s portfolio shows investments in just two index funds — the SPDR S&P 500 ETF and the Vanguard 500 Index Fund ETF — making up around 0.01% of the company’s investments combined.

Here are three reasons why an expert investor may not find index funds suitable for them.

Concentration

One of the primary reasons people invest in an index fund is diversification. A fund that tracks the S&P 500, for instance, is supposed to give you exposure to 500 different companies. But because the stocks within the fund are weighted in proportion to the market cap of each corresponding company, your investment will be skewed to the largest firms, and that means you’ll be more exposed to certain sectors than you might realize.

For instance, technology firms account for a whopping 26% of the S&P 500’s market value, according to Visual Capitalist, citing data from Slickcharts. Any weakness in this sector could thus have an outsized impact on performance.

Investors looking for a more balanced approach might want to consider individual stocks in niche industries or even foreign stocks.

Performance

Index funds have certainly delivered great performance in the past. From 1957 through Dec. 31, 2022, the S&P 500 delivered an average annual growth rate of 10.15%, according to Investopedia. This has been excellent for long-term investors.

But past performance is not an indication of future returns. Just because historical returns were high doesn’t mean that’s the rate of growth investors can expect in the future.

Read more: ‘It makes an enormous difference’: Warren Buffett says this simple ‘trick’ is the key to earning a generous retirement nest egg

Meanwhile, some individual stocks are currently growing at faster rates. Defense contractor TransDigm Group, for example, reported 20% revenue growth and 53% operational income growth, year over year, in the second fiscal quarter. The stock is up around 38% year to date.

If you’re looking for accelerated growth or better dividends, you might prefer individual stocks over index funds.

Valuation

The S&P 500 is trading at a price-to-earnings (P/E) ratio of around 25. That’s reasonable given its historical performance, but there’s no doubt that some individual stocks and specific sectors are cheaper than the market average.

Verizon, for instance, has a P/E of around 6.4 and also offers a dividend yield of 7.8%. Several other stocks trade at single-digit P/E ratios and have robust track records and recognizable brands.

Put simply, if you’re looking for something cheap or are willing to bet on an opportunity that is flying below the radar, index funds might not be your best bet.

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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.