Complexity and lots of trading is usually a recipe for underperformance.
Becoming a professional fund manager isn’t easy, but it turns out that 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 better than the average actively managed mutual fund. While it might be possible for many professional funds to outperform over the short run, it gets harder and harder as time goes on.
There’s a big drag on active funds’ investment returns: fees. As a result, just 12% of active mutual funds outperformed the S&P 500 index over the past 15 years, according to S&P Global‘s SPIVA scorecard. Identifying those 12% ahead of time is practically impossible, 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 (VOO 0.94%).
It’s not going to turn heads when you mention it at your next dinner party, but it does offer one of the highest expected returns of any single investment you can buy. And it’ll do far better than an actively managed mutual fund picked by random chance.
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Why it’s so hard for professionals to outperform
By and large, institutional investors account for the vast majority of trading volume, especially among large-cap stocks. Institutional investors typically account for 85% of trading volume. Individual investors aren’t nearly as active in the market, and they hold much less capital.
In other words, professionals, as a group, are extremely representative of the overall market. As such, the average professional investor should only expect to produce returns in line with the 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 loads. The median expense ratio on an actively managed mutual fund last year was 1.01%.
A 1% drag on average investment returns leads to significant underperformance over time. That’s why the SPIVA scorecard shows over 40% of fund managers outperforming over the past year, but just 12% outperforming over the past 15 years.
Yes, there are fund managers that can consistently outperform the index in most years, earning their fees. However, it’s hard to determine who those fund managers are ahead of time. Basing an investment decision on past performance rarely works out. Of the large-cap funds that were in the top quartile of performers in 2019, not a single one remained in the top quartile over the next four years. In fact, fund performance is less persistent than what’s expected under random distribution.
Lower your cost of market participation
Several investors have expounded on the keys to successful investing, but by far one of the biggest factors is controlling your cost of participation. 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 where he tells the parable of the Gotrocks family. The family once owned every American corporation, but saw their wealth destroyed by “helpers” promising to help individual family members outperform their relatives for just a small fee. He concluded with a simple analogy to Newton’s laws of motion: “For investors as a whole, returns decrease as motion increases.”
The simplest way to reduce motion and keep your helper fees low is to buy an index fund. The Vanguard S&P 500 ETF has an expense ratio of just 0.03% and and extremely low tracking error. It only trades when changes are made to the S&P 500 index each quarter, and it rarely produces a taxable event for its shareholders. The results are net returns extremely close to the gross returns of the constituents of the S&P 500 index.
While a hot, actively managed mutual fund and a star fund manager may look attractive, digging into the data suggests it’s probably not a smart investment. On average, things will work out much better if you focus on the fund with the lowest fees over the past year instead of the fund with the best performance.
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.
