Professional fund managers invest billions of dollars for investors. They are often highly educated, have years of experience in the investment field, and are well paid for their skills and expertise. But the truth is that most of them are not worth the fees they charge.
You don’t need an advanced degree or any special insider knowledge to outperform the vast majority of actively managed mutual funds. A simple strategy can beat about 88% of them. Warren Buffett famously bet half a million dollars on this strategy, expecting it to beat every hedge fund manager in 10 years.
He won the bet.
All you have to do is S&P500 Index funds, such as the Vanguard S&P 500 ETF (WKN: A2P522)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 (net of fees) to relevant S&P benchmark indices 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 past 15 years (as of the end of 2023). Even looking at a shorter three-year period, about 80% failed to beat the benchmark.
There are several factors that lead to such dismal results for active funds as a group.
First, it’s important to understand how the stock market works. There’s always someone on both sides of a transaction; for every buyer, there’s a seller. And in large-cap stocks, the people buying and selling shares are usually institutional investors. In other words, one fund manager will usually sell his 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 slightly better than 50/50. However, 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 to be compensated. This 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. These fees can rise well above 1%. This means that the fund manager must beat the market by the fee it charges its clients to break even. And that’s much 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 about 40%. And very few can beat the market consistently enough each year to come out on top over the long term.
Reduce your “participation costs”
If you want to outperform the average investor, you need to lower what Vanguard founder Jack Bogle called the “cost of participation,” which is the cost you pay to invest your money.
In the 25-plus years since Bogle coined the term, investing has become easier and less expensive. Transaction costs for portfolios are close to zero because most brokers do not charge commissions on stock purchases. On average, mutual fund expense ratios have also dropped significantly since the mid-1990s. Still, an investor should try to keep costs as low as possible, and that means avoiding unnecessary fees.
Since active mutual funds cannot beat their fees on average, these fees should be considered unnecessary. You can buy the Vanguard S&P 500 ETF and get virtually 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 a long history of making more money than their fees, it’s not easy to identify these funds in advance. And you never know if the results are down to skill or luck, so you can’t be sure the fund will continue its winning streak.
Therefore, an S&P 500 index fund is still your best choice.
Why is the Vanguard S&P 500 ETF Buffett’s first choice?
In his big bet against fund managers, Buffett invested his money in the Vanguard S&P 500 index fund. Berkshire-Hathaway also owns a small portion of the S&P 500 ETF in his stock portfolio. There are a few things that make it his top pick.
First, as mentioned above, the expense ratio is 0.03%, which is one of the best in the industry.
Second, it has a very low tracking error. Tracking error is how consistently (or closely) the ETF tracks the index it is measured against. This can make a big difference to someone who invests regularly. You want the fund to mirror the performance of the index so that over the long term your results will match the index’s results. It’s not worth sacrificing a 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 a top choice. It’s a great option not only among other index funds, but among all large-cap equity funds.
Should you invest $1,000 in the Vanguard S&P 500 ETF now?
Before you buy shares of the Vanguard S&P 500 ETF, consider the following:
The Motley Fool Stock Advisor The analyst team has just published what they believe to be The 10 best stocks for investors to buy now…and the Vanguard S&P 500 ETF wasn’t one of them. The 10 stocks that made the cut could deliver huge returns in the years to come.
Consider when NVIDIA created this list on April 15, 2005… if you had invested $1,000 at the time of our recommendation, You would have $757,001!*
Stock Advisor offers investors an easy-to-understand plan for success, including instructions on how to build a portfolio, regular updates from analysts, and two new stock recommendations per month. The Stock Advisor Service has more than quadrupled the return of the S&P 500 since 2002*.
View the 10 stocks »
*Stock Advisor returns as of June 24, 2024
Adam Levy does not own any stocks mentioned. The Motley Fool owns and recommends Berkshire Hathaway, S&P Global, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
This simple investment strategy can outperform 88% of professional fund managers. This article was originally published by The Motley Fool.
