Professional fund managers are in charge of investing billions of dollars for investors. They’re often highly educated, have years of investment experience, and get paid well for their skills and expertise. But the truth is most aren’t worth the fees they charge.
It doesn’t take an advanced degree or special insider knowledge to do better than the vast majority of actively-managed mutual funds. A simple strategy can beat about 88% of them. It’s a strategy Warren Buffett famously bet half a million dollars on with the expectation it could beat any hedge fund manager over 10 years.
He won the bet.
All you need to do is buy an S&P 500 index fund, such as the Vanguard S&P 500 ETF (NYSEMKT: VOO), and you can expect better long-term returns than most active mutual funds.
Why 88% of active large-cap funds can’t beat a simple index fund
S&P Global publishes its SPIVA (S&P Indices Versus Active) scorecards twice a year. The scorecard compares the performance of active mutual funds (after fees) to relevant S&P benchmark indexes over periods of one, three, five, 10, and 15 years. It found that 88% of active large-cap funds failed to beat the S&P 500 over the last 15 years as of the end of 2023. Even when you look at a shorter three-year period, about 80% failed to beat the benchmark.
There are a couple of factors that lead to such dismal results for active funds as a group.
First, it’s important to consider how the stock market works. There’s always someone on either side of a transaction; for every buyer, there’s a seller. And among large-cap stocks, the people buying and selling shares are mostly institutional investors. In other words, one fund manager is typically selling their shares to another fund manager. They can’t both be right.
Since large institutions make up most of the market, the odds of outperforming the market as an active fund manager may be only a little better than 50/50. But the second factor severely diminishes the returns passed on to investors in actively-managed funds.
Fund managers, their teams, and the institutions they work for all require compensation. That means mutual fund investors have to pay fees. The most common fee is the expense ratio, which captures a portion of the assets under management. Those fees can climb well over 1%. That means the fund manager has to outperform the market by the fee they charge clients just to break even. And that’s a lot harder than simply beating the market by a few basis points.
As a result, the percentage of actively-managed mutual funds that outperform the S&P 500 in any given year is only around 40%. And very few can consistently beat the market by enough every year to come out ahead in the long run.
Reduce your “cost of participation”
If you want to outperform the average investor, the key is reducing what Vanguard founder Jack Bogle called “the cost of participation.” Those are the costs you have to pay to invest your money.
It’s become easier and less expensive to invest over the 25-plus years since Bogle coined that term. Portfolio transaction costs are near zero with most brokerages waiving commissions on stock purchases. On average, expense ratios for mutual funds have declined considerably from the mid-90s too. Still, an investor should aim to keep costs as low as possible, and that means avoiding unnecessary fees.
Since active mutual funds cannot outperform their fees, on average, those fees should be deemed unnecessary. You can buy the Vanguard S&P 500 ETF and practically match the market return for a fee of just 0.03%, or $3 for every $10,000 you invest.
And while it’s true some fund managers have outperformed their fees for a long time, identifying those funds beforehand is not so simple. What’s more, there’s no telling whether the results came from skill or luck, so you can’t be certain the fund can continue its winning streak.
As a result, your best bet remains an S&P 500 index fund.
What makes the Vanguard S&P 500 ETF Buffett’s top pick?
In Buffett’s big bet against fund managers, he put his money in the Vanguard S&P 500 index fund. Berkshire Hathaway owns a small amount of the S&P 500 ETF in its equity portfolio as well. There are a few things that make it his top pick.
First, as mentioned, it has an expense ratio of 0.03%. That’s one of the best in the industry.
Second, it has a very low tracking error. Tracking error tells you how consistently close (or wide) the ETF tracks the index it’s benchmarked to. That can make a big difference for someone investing on a regular schedule. You want the fund to reflect the performance of the index, so your results match the results of the index over the long run. It’s not worth sacrificing a low tracking error for a lower expense ratio, especially when the Vanguard fund is so cheap already.
There are many options to choose from, but the Vanguard S&P 500 ETF stands out as a top choice. It’s a great option not just among other index funds but among all large-cap stock funds.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway, S&P Global, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
You Can Outperform 88% of Professional Fund Managers by Using This Simple Investment Strategy was originally published by The Motley Fool
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