Becoming a professional fund manager isn’t easy, but it turns out beating the returns of some of the best fund managers in the world is. It’s a quirk of stock market mechanics that makes a simple investment strategy far superior to the average actively managed mutual fund. While it’s possible for many professional funds to outperform in the short term, it becomes increasingly difficult as time goes on.
There is a major drag on active funds’ investment returns: costs. As a result, only 12% of active investment funds outperformed the S&P 500 index of the past 15 years, according to S&P Worldwide‘s SPIVA scorecard. It’s virtually impossible to identify that 12% in advance, so the best strategy to outperform professional fund managers is to buy a simple S&P 500 index fund like the Vanguard S&P 500 ETF (NYSEMKT: VOO).
It won’t turn heads when you mention it at your next dinner party, but it does offer one of the highest expected returns of any investment you can buy. And it will far outperform an actively managed mutual fund picked by chance.
Why it’s so hard for professionals to outperform
In general, institutional investors account for the vast majority of trading volume, particularly among large-cap stocks. Institutional investors typically account for 85% of trading volume. Individual investors are not nearly as active in the market and have much less capital.
In other words, professionals as a group are highly representative of the overall market. As such, the average professional investor should only expect returns that are in line with overall market returns.
The underperformance problem arises because professional fund managers charge high fees for their services. These fees come in the form of expense ratios and fund expenses. The median expense ratio of an actively managed mutual fund was 1.01% last year.
A 1% decline in average investment returns over time leads to significant underperformance. That is why the SPIVA scorecard shows that over 40% of fund managers outperformed last year, but only 12% outperformed over the last 15 years.
Yes, there are fund managers who can consistently outperform the index in most years and thus earn their fees. However, it is difficult to determine who these fund managers are in advance. Basing an investment decision on past performance rarely works. Of the large-cap funds that were in the top quartile of performers in 2019, none remained in the top quartile over the subsequent four years. In fact, fund performance has been less consistent than would be expected with random distribution.
Reduce your costs for market participation
Several investors have outlined the keys to successful investing, but one of the biggest factors by far is controlling your participation costs. Vanguard founder Jack Bogle coined the idea of the cost matters hypothesis: “Gross returns in the financial market minus the costs of financial intermediation equal the net returns actually delivered to investors.”
Warren Buffett echoes the idea in his 2005 letter to shareholders, in which he tells the parable of the Gotrocks family. The family once owned all of America’s corporations, but saw its wealth destroyed by “helpers” who promised to help individual family members outperform their kin for little compensation. He concluded with a simple analogy to Newton’s laws of motion: “For investors as a whole, returns diminish as motion increases.”
The easiest way to reduce volatility and keep your auxiliary costs low is to buy an index fund. The Vanguard S&P 500 ETF has an expense ratio of just 0.03% and an extremely low tracking error. It only trades when there are quarterly changes to the S&P 500 index, and it rarely produces a taxable event for its shareholders. The results are net returns that are extremely close to the gross returns of the S&P 500 index constituents.
While a hot, actively managed mutual fund and a star fund manager may look attractive, a dive into the data suggests it’s probably not a smart investment. On average, you’ll be much better off focusing on the fund with the lowest fees over the past year rather than the one with the best performance.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends S&P Global and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
Want to Outperform 88% of Professional Fund Managers? Use This Simple Investment Strategy. was originally published by The Motley Fool
