Professional fund managers are responsible for investing billions of dollars for investors. They are often highly educated, have years of investing experience, and are paid well for their skills and expertise. But the truth is that most are not worth the fees they charge.
You don’t need a college degree or specialized knowledge to outperform the vast majority of actively managed mutual funds. A simple strategy can beat about 88% of them. Warren Buffett bet half a million dollars on this strategy hoping it could beat any hedge fund manager over 10 years.
He won the bet.
All you have to do is buy a S&P 500 index fund, such as Vanguard S&P 500 Exchange Traded Fund (NYSEMKT:VOL)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 S&P Indices Versus Active (SPIVA) scorecards twice a year. The scorecard compares the performance of active mutual funds (after fees) to relevant S&P benchmarks over one-, three-, five-, 10-, and 15-year periods. It found that 88% of large-cap active funds had failed to beat the S&P 500 over the past 15 years as of the end of 2023. Even when looking at a shorter three-year period, about 80% had failed to beat the benchmark.
Several factors are responsible for such disappointing results for active funds as a group.
First, it’s important to understand how the stock market works. There’s always someone on each side of a trade; for every buyer, there’s a seller. And among large-cap stocks, the people buying and selling stocks are mostly institutional investors. In other words, one fund manager typically sells his stock to another fund manager. They can’t both be right.
With large institutions making up the majority of the market, the odds of outperforming the market as an active fund manager may be just over 50/50. But the second factor significantly reduces the returns passed on to investors in actively managed funds.
Fund managers, their teams, and the institutions they work for all need compensation. That means mutual fund investors have to pay fees. The most common is the expense ratio, which is a portion of assets under management. These fees can be well over 1%. That means the fund manager has to outperform the market based on the fees they charge their 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 a given year is only about 40%. And very few of them manage to beat the market enough each year to get by in the long run.
Reduce your “cost of participation”
If you want to perform better than the average investor, the key is to reduce what Vanguard founder Jack Bogle calls “the cost of participation.” These are the costs you have to pay to invest your money.
Investing has become easier and cheaper in the 25 years since Bogle coined the term. Portfolio transaction costs are close to zero, with most brokerages waiving commissions on stock purchases. On average, mutual fund expense ratios have also declined significantly since the mid-1990s. Still, an investor should strive to keep costs as low as possible, which means avoiding unnecessary fees.
Since active mutual funds cannot surpass their fees, those fees should on average be deemed unnecessary. You can buy the Vanguard S&P 500 ETF and virtually match the market return for a fee of just 0.03%, or $3 for every $10,000 you invest.
And while it’s true that some fund managers have outperformed their fees for a long time, it’s not that easy to identify these funds in advance. Additionally, it is impossible to know whether the results are the result of talent or luck, and so it is uncertain whether the fund can continue its streak of success.
Therefore, your best choice 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 money managers, he put his money in the Vanguard S&P 500 index fund. Berkshire Hathaway also has a small portion of the S&P 500 ETF in its stock portfolio. Several reasons make it its first choice.
First, as mentioned, its expense ratio is 0.03%. This is one of the best in the industry.
Second, its tracking error is very low. Tracking error tells you how closely (or far) the ETF tracks the index it is compared to. This can make a big difference to someone who invests regularly. You want the fund to reflect the performance of the index, so that your results match the index’s results over the long term. It’s not worth sacrificing low tracking error for a lower expense ratio, especially when the Vanguard fund is already so cheap.
There are many options to choose from, but the Vanguard S&P 500 ETF stands out as the top pick. It is a great option not only 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 holds positions in and recommends the Berkshire Hathaway, S&P Global, and Vanguard S&P 500 ETFs. The Motley Fool has a disclosure policy.
You can outperform 88% of professional money managers using this simple investing strategy, originally published by The Motley Fool.