Wall Street is full of some of the sharpest investors in the world. Professional fund managers are usually highly educated, hardworking and extremely smart. So it may seem impossible to find a way to outperform these financial superheroes.
But it doesn’t take a very complex trading plan to stay ahead of 98% of professional mutual fund managers over the long term. You don’t have to spend all your free time studying the markets, keeping up with the news and developing your own strategies for when to buy and sell. The less work you do, the better the strategy works.
If you want to beat the pros, your best bet is to buy a broad-based index fund and just hold it. The strategy will deliver long-term after-tax returns that are better than approximately 98% of actively managed mutual funds.
S&P Global publishes a report twice a year called the S&P Indexes Versus Active (SPIVA) Scorecard. The report shows the performance of actively managed mutual funds compared to their S&P benchmark index over time. The latest SPIVA scorecard shows that 90% of actively managed investment funds underperformed S&P Composite 1500 index over the past 10 years.
There are several factors at play. First and foremost, it’s important to remember that for every stock market transaction, someone has to buy shares and someone has to sell those shares. Because the vast majority of trading volume comes from institutional investors, both sides of the trade are typically represented by a professional fund manager. One buys what the other sells, but they can’t both be on the right side of the deal.
That dynamic helps explain why the average investment with a professional fund manager could deliver returns roughly in line with the market average.
However, the challenge increases as the fund manager manages more capital. A smart investor may be able to outperform the market relatively consistently while managing a small sum of money. But it’s a lot harder to maneuver in the market and generate high returns if you have a lot of capital to invest. But since strong performance tends to attract a lot of investor attention, it becomes increasingly difficult to perform consistently in the long term.
Even Warren Buffett recognizes this challenge. Already in his 1996 letter to Berkshire Hathaway shareholders, he wrote, “an abundance of funds tends to dampen returns.” As Berkshire Hathaway’s investable assets have ballooned over the past 28 years, Buffett has found it even more difficult to significantly outperform the market on a consistent basis.
At Berkshire’s annual shareholder meeting in May this year, he told the audience: “I wouldn’t like to run $10 billion right now – $10 million, I think, Charlie [Munger, his late partner] otherwise I could get high returns.” For reference, Buffett currently manages more than $600 billion in investable assets.
So the odds are against fund managers from the start. But it’s important to remember that they don’t work for free. That’s why mutual funds charge fees. They pay the managers, and they can keep a little (or a lot) for themselves. Therefore, managers must not only outperform the benchmark index; they must also outperform the index plus fund fees. The data shows that 90% of them don’t do this.
Investing in an actively managed mutual fund comes with an additional fee that investors ignore at their peril: taxes. Active mutual funds tend to generate taxable income for their shareholders, which can be a major drag on investment returns.
Every time you sell an investment, you have to pay taxes on the profits you made from that investment, called capital gains. If you hold the investment for more than a year, you will receive a preferential tax rate. If you hold it for a year or less, you will have to pay the same tax rate as your income tax. Actively managed mutual funds tend to generate capital gains, and the holding period is often less than one year. These profits are passed on to shareholders.
S&P Global calculated the after-tax returns of the actively managed mutual funds in the SPIVA Scorecard by using the highest marginal tax rates for both long-term gains and income. It also calculated the returns of its indices based on the same tax rates, taking into account dividend payments and any capital gains from changes in the constituent stocks.
The results of the analysis showed that 98% of actively managed mutual funds have failed to outperform the S&P 1500 over the past decade, when you take taxes and fees into account. If you only focus on large cap funds that try to beat the market S&P500the number is still 98%.
The results are clear: if you take into account everything that goes against a professional fund manager, you are very unlikely to choose one that will outperform the market index over the long term. That’s why you’re better off buying an index fund.
If you want to exactly replicate S&P Global’s results, you may be interested in the SPDR portfolio S&P 1500 Composite Stock Market ETF (NYSEMKT: SPTM). With an expense ratio of just 0.03% and historically low tracking error, this ETF will deliver results as close to the S&P 1500’s total return as possible.
Another option to consider is the Vanguard Total Stock Market ETF (NYSEMKT: VTI). The S&P indexes have return requirements that can filter out some of the best growth stocks. If adding a little exposure to not-yet-profitable companies is important to you, the Vanguard Total Market fund may be a better fit.
On the other hand, if you are more interested in large and profitable companies, the Vanguard S&P 500 ETF (NYSEMKT:VOO) is another excellent choice with a low expense ratio and a strong track record of closely tracking the underlying index.
Many actively managed mutual funds will outperform the above index funds in any given year. But if you’re a long-term investor looking for the best returns over the next decade and beyond, these are probably better choices than any actively managed fund.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool holds and recommends Vanguard S&P 500 ETF and Vanguard Total Stock Market ETF. The Motley Fool has a disclosure policy.
Do you want to outperform 98% of professional investment fund managers? Buy this first investment and hold it forever. was originally published by The Motley Fool
