Professional fund managers get paid a lot of money to take charge of billions of dollars in assets for investors. They tend to have a certain level of education and expertise, which should give them a leg up on the average Joe investing at home. Unfortunately, most professionals aren't worth the price.
Anyone can outperform 92% of active fund managers over the long run, and they don't need any special insights into the market to do so. In fact, the necessary approach is about as hands-off as it gets.
All you need to do is buy an S&P 500 index fund, such as the Vanguard S&P 500 ETF (VOO 0.56%), and hold it forever.
92% of active large-cap fund managers underperform
S&P Global publishes its SPIVA (S&P Indices Versus Active) scorecards twice a year, comparing the performance of active funds and the S&P indexes over various periods. It found 92% of active large-cap fund managers underperformed the S&P 500 over the last 15 years as of the end of June. Even over the past year, less than 40% could outperform.
What's going on here?
Consider that the stock market is largely controlled by institutional investors. On any given day, over 80% of the volume traded in large-cap stocks comes from big institutions moving money around. In other words, the market price is dictated by institutional investors.
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These super-smart, highly experienced fund managers are operating in a very efficient market because they're working against other super-smart, highly experienced fund managers. That completely wipes out their advantage over the average Joe investor, leaving their odds of outperforming the market somewhere around 50/50.
But they don't just have to outperform the market. They have to outperform by enough to justify their fee. And they have to do it year after year. That's a lot to ask.
Jack Bogle and Warren Buffett explain why active fund managers cannot outperform the market
In a 1997 paper, Vanguard founder Jack Bogle noted a simple reality of investing in the stock market: "Investors as a group must underperform the market, because the costs of participation -- largely operating expenses, advisory fees, and portfolio transaction costs -- constitute a direct deduction from the market's return."
Warren Buffett referred to the same market forces in his parable of the Gotrocks, who lost their fortune to "helpers" like brokers, managers, and financial advisors. He sums up the parable with this simple idea: "For investors as a whole, returns decrease as motion increases."
By and large, active fund managers trade a lot more than an index fund. They create a lot more "motion."
The fund manager who can consistently outperform the market by more than their fees for an extended period of time is rare, but they do exist. But even if you find one, you can't know for certain until after they've actually outperformed the market. Even then, the decision to continue investing with the fund manager requires you to determine whether the results came from skill or luck. That means picking the right fund and fund manager is a very difficult task.
Therefore, the fund option with the highest expected return over the long run is going to be an index fund. You'll outperform 92% of active fund managers. That's because index funds offer the lowest cost of participation, the core factor dragging down returns, as Bogle put it.
What to look for in an index fund
There are two main factors that you need to consider when buying an index fund in order to lower your "costs of participation":
- Expense ratio: This one is straightforward. It's the percentage of assets you'll pay to the fund manager to manage the portfolio. Some index funds have extremely low expense ratios of just a few basis points. The Vanguard S&P 500 ETF, for example, has an expense ratio of just 0.03%. That means you'll pay $3 for every $10,000 you invest in the fund.
- Tracking error: Tracking error is an oft-overlooked measure of index ETFs. Tracking error tells you how consistently close (or wide) the ETF tracks the index it's benchmarked to. If your fund has a high tracking error and low expense ratio, it could end up costing more than an ETF with a very low tracking error and high expense ratio. That's because investor returns won't match the index as closely, which increases the risk of underperforming the index based on when you buy or sell.
There are plenty of great index funds out there, and the odds are very good that buying one is a better choice than buying an actively-managed mutual fund.
