How to invest in the share market in 2025: index funds, managed funds, or direct shares?  

share market

If you’ve been following my blogs for a while, you’ll know that I’m a strong advocate for evidence-based investment strategies. Put simply, I only employ investment strategies that have a proven track record – where the evidence overwhelmingly shows that a rules-based approach has consistently delivered strong returns over many decades. This approach gives us confidence that, by employing the same rules-based approach, we can achieve similar outcomes. Taking this approach minimises investment risk and, in turn, increases the likelihood of achieving a client’s financial and lifestyle goals. 

It’s been over seven years since I last wrote about why passive investing almost always outperforms other strategies, like investing in actively managed funds or stock picking. So, I thought it was time to revisit and update this important principle. 

Why ruled-based share investing wins  

Global index and benchmarking business, S&P Dow Jones has been studying the effectiveness of indexing for more than two decades. Its research is published under the “S&P Indices Versus Active” (SPIVA®) brand, with annual updates released around February. The SPIVA reports compare the performance of all publicly available actively managed funds to their relevant indices. Here are some key highlights: 

  • Australia: Over the past 15 years, more than 85% of Australian actively managed funds failed to outperform the ASX200 index. Put another way, fewer than 15% of active funds delivered better returns than the index. But here’s the catch. It’s not the same 15%. For example, of the 76 Australian active managers in the top quartile for performance in 2021, only 16 stayed in the top quartile in 2022, and just one remained by 2023 – so only one manager was able to beat the index 3 years in a row! To consistently beat the index with active managers, you would need to accurately identify who’s going to be in the top 15% and then switch to the next winners every 1 to 2 years, an approach that would incur high transaction costs and tax liabilities. 
  • United States: The data is even more striking – over 90% of actively managed US funds failed to beat the S&P 500 index over the past 15 years. Among the 508 US active managers in the top quartile in 2021, only 178 (35%) remained in the top quartile in 2022, and just two stayed in the top quartile by 2023. 

If professional fund managers can’t consistently outperform the market, what chance do novice, everyday investors have by investing in direct stocks? Virtually no chance!  

I’m not saying that it is impossible for active managers to outperform the index consistently over time. The data doesn’t include private or restricted funds, so there could be a few “unicorns” out there. However, it’s clear that relying on active management is a high-risk strategy with a significant chance of underperforming. 

Index funds, by contrast, offer several advantages in addition to better returns: 

  • Low Turnover: Index funds typically have minimal turnover, resulting in fewer realised capital gains and greater tax efficiency. In contrast, many actively managed funds generate high turnover, making most of their returns taxable each year. 
  • Lower Fees: Index funds charge much lower fees, which reduces investment risk. Fees are certain, while returns are not. 

The data reinforces why index investing is such a compelling, evidence-based approach to building wealth. 

Large-cap stocks drove indexes in 2024 

The ASX 200 index rose 11.55% in 2024. According to Van Eck, the banks’ rally throughout 2024 drove more than half of that total return with CBA accounting for 3.47% of the index’s total return in 2024. Westpac and Nab’s contribution was 3.01%. Therefore, the remaining 197 other stocks that constitute the ASX200 only returned 5.07% p.a. in 2024, which is a relatively poor result.  

It is noteworthy that earnings growth is not responsible for driving higher bank share prices. In fact, earnings per share growth for all three banks was negative in 2024! Therefore, multiple expansion is the sole reason for this performance. That said, Westpac and nab appear to be fairly valued, trading on a forward PE ratio of 15 to 16 times. However, Morningstar has argued that CBA is the most expensive bank in the developed world trading on a forward PE of 25 times.  

The chance of banks driving the index again in 2025 is relatively low. In fact, CBA in particular, could be a drag on the index.  Maybe investors should consider index funds that provide lower exposure to the banks in 2025.   

Same but different in the US  

In the US, the S&P 500 delivered an impressive return of 25.02% in 2024. However, much of this growth was driven by the so-called “Magnificent Seven” stocks (Apple, Microsoft, Amazon, Google, Meta, NVIDIA and Tesla), which contributed approximately 55% of the index’s total gains for the year. These seven companies now account for about one-third of the S&P 500’s market capitalisation. 

Unlike in Australia, the Magnificent Seven delivered robust earnings growth, averaging around 33% for the first three quarters of 2024. This level of growth arguably supports, to some extent, their significant share price increases. However, the rest of the index (remaining 493 companies), experienced lower growth of around 4.2% for the same period.  

That said, I’d argue that the earnings growth of the Magnificent Seven is already more than fully priced into their current valuations. These companies are trading on price-to-earnings (PE) ratios ranging from 25 to an eye-watering 110 times, with a median of 39 times earnings. 

The big question is whether the Magnificent Seven can sustain this earnings growth in 2025. Perhaps the Federal Reserve’s 1% rate cut in 2024 together with a pro-business Republican government will give the rest of the S&P 500 the boost it needs to finally deliver meaningful earnings growth in the coming year. 

How did alternative index strategies perform in 2024? 

Traditional market-capitalisation indexing tends to give investors significant exposure to growth companies since the allocation is directly tied to share prices. However, growth companies have become quite expensive, trading on a PE ratio of about 27 times – well above the 10-year average of 22 times. To reduce portfolio risk, it may be prudent for investors to consider underweighting growth stocks. One way to achieve this is by using indexing strategies that allocate based on metrics other than price – I profiled 4 last year – let’s investigate how they performed in 2024.  

The equal-weighted S&P 500 index reduces the concentration risk associated with large-cap stocks. It is currently trading on a forward PE ratio of around 17 times, which aligns with its 10-year average and is far more attractive than the traditional market-cap-weighted S&P 500 index, trading at roughly 29 times. However, the trade-off is less exposure to the “Magnificent Seven” stocks, which caused the equal-weight index to underperform the S&P 500 by a massive 12% in 2024. 

Dimensional indexing stood out in 2024, delivering a return of 26.7%, outperforming the S&P 500 index. In contrast, traditional value-focused indexes, such as Vanguard’s VVLU, underperformed with a return of 18.94%. Given the dominance of large-cap companies and the risks they pose to future returns, I think a value tilt makes sense for many portfolios. 

Quality-focused indices, like QLTY and QUAL, performed exceptionally well in 2024, driven by their exposure to the Magnificent Seven. They returned 26.07% and 30.60%, respectively. 

You must consider both risk and future returns  

The performance of these different indexing strategies last year underscores the importance of diversification. Spreading investments across a mix of strategies helps optimise portfolio risk and potential returns.  

For example, a quality index can provide exposure to the Magnificent Seven, but only if these companies meet the quality metrics. An equal-weight index, on the other hand, offers greater exposure to mid-and small-cap stocks, helping you move away from large-cap dominance. Dimensional and value-focused indexing can further reduce portfolio risk by tilting towards undervalued stocks. That said, it’s still important to include some traditional market-cap indexing in your portfolio for broad market exposure. 

The goal isn’t to try to predict what will happen in 2025. Remember, predicting short-term market movements is as difficult as forecasting the weather. Instead, focus on constructing a portfolio that is likely to deliver the best outcomes over the next 5 to 10 years. 

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