Wall Street is full of some of the sharpest investors in the world. Professional fund managers tend to be highly educated, hard-working, and extremely smart. So, finding a way to outperform these finance whizzes might seem impossible.
But it doesn’t take a highly complex trading plan to come out ahead of 98% of professional mutual fund managers over the long run. You don’t need to spend all of your free time studying the markets, staying up-to-date on the news, and developing proprietary strategies for when to buy and sell. In fact, the less work you do, the better the strategy works.
If you want to beat the professionals, your best bet is to buy a broad-based index fund and just hold onto it. The strategy will produce after-tax returns better than about 98% of actively managed mutual funds over the long run.
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S&P Global publishes a report called the S&P Indexes Versus Active (SPIVA) Scorecard twice a year. The report shows the performance of actively managed mutual funds relative to their S&P benchmark index over time. The most recent SPIVA Scorecard shows 90% of actively managed mutual funds underperformed the S&P Composite 1500 index over the past 10 years.
There are several factors at play. First and foremost, it’s important to remember that each trade in the stock market requires someone to buy shares and someone to sell shares. Since the vast majority of trading volume comes from institutional investors, both sides of the trade are typically represented by a professional fund manager. One’s buying what the other’s selling, but they can’t both be on the right side of the deal.
That dynamic helps explain why the average investment with a professional fund manager might produce returns roughly in line with the market average.
However, the challenge is compounded as the fund manager starts managing more capital. A clever investor may be able to outperform the market relatively consistently while managing a small sum of money. But it’s a lot harder to maneuver in the market and generate high returns when you have a lot of capital to invest. But since strong performance tends to attract a lot of attention from investors, consistently outperforming over the long run becomes increasingly difficult.
Even Warren Buffett recognizes this challenge. As far back as his 1996 letter to Berkshire Hathaway shareholders, he wrote “an abundance of funds tends to dampen returns.” As Berkshire Hathaway’s investable assets have ballooned over the last 28 years, Buffett has found it even harder to significantly outperform the market on a consistent basis.
At Berkshire’s annual shareholder meeting in May this year, he told the audience, “I would not like to be running $10 billion now — $10 million, I think Charlie [Munger, his late partner] or I could earn high returns on.” For reference, Buffett currently manages over $600 billion
in investable assets.
So, the odds are already against fund managers from the start. But it’s important to remember that they don’t work for free. That’s why mutual fund companies charge fees. They go toward paying the managers, and they can keep a little (or a lot) for themselves. Therefore, managers don’t just have to outperform the benchmark index — they have to outperform the index plus the fund fees. The data show 90% of them fail to do so.
Investing in an actively managed mutual fund comes with an added fee that investors ignore at their own peril: taxes. Active mutual funds have a tendency to produce taxable income for their shareholders, which can be a big drag on investment returns.
Whenever you sell an investment, you have to pay taxes on any gains you earned from that investment, called capital gains. If you hold the investment longer than one year, you’ll get a preferred tax rate. If you hold it for a year or less, you’ll have to pay the same tax rate as your income taxes. Actively managed mutual funds tend to produce capital gains, and the holding period is often less than one year. Those gains are passed on to the shareholders.
S&P Global calculated the after-tax returns of the actively managed mutual funds in the SPIVA Scorecard by using the highest marginal tax rates for both long-term capital gains and income. It also calculated the returns of its indexes based on the same tax rates, taking into account dividend distributions and any possible capital gains from changes in the constituent stocks.
The results of the analysis showed that 98% of actively managed mutual funds failed to outperform the S&P 1500 over the past 10 years when you account for taxes and fees. If you only focus on large-cap funds trying to beat the S&P 500, the number is still 98%.
The results are clear: When you factor in everything going against a professional fund manager, it’s highly unlikely you’ll pick one that will outperform the market index over the long run. That’s why you’re better off buying an index fund.
If you want to replicate S&P Global’s results exactly, you may be interested in the SPDR PortfolioS&P 1500 Composite Stock Market ETF(NYSEMKT: SPTM). With an expense ratio of just 0.03% and a historically low tracking error, this ETF will produce results as close to the S&P 1500’s total return as you can find.
Another option to consider is the Vanguard Total Stock Market ETF(NYSEMKT: VTI). The S&P indexes have profitability requirements that can filter out some of the best growth stocks. If adding a little bit of exposure to not-yet-profitable businesses is important to you, the Vanguard Total Market fund may be a better fit.
On the other hand, if you’re more interested in large and profitable businesses, the Vanguard S&P 500 ETF(NYSEMKT: VOO) is another great choice with a low expense ratio and strong record of tracking the underlying index closely.
Many actively managed mutual funds will outperform the above index funds in any given year. But if you’re a long-term investor looking for the best returns over the next decade and beyond, these are likely better choices than any actively managed fund you can find.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF and Vanguard Total Stock Market ETF. The Motley Fool has a disclosure policy.
