You Can Outperform Nearly 92% of Professional Fund Managers by Using This Simple Investment Strategy

Professional fund managers are some of the brightest minds on Wall Street. There’s a reason people trust them with billions of dollars in capital. Practically all of them are highly educated and highly experienced in the financial markets, giving them a serious advantage when it comes to outperforming the average individual investor on Main Street.

But the truth is that you can outperform the pros by using a simple investment strategy that nearly every professional can’t touch. If you used this strategy over the last 20 years, you’d have outperformed almost 92% of all domestic large-cap mutual funds. The odds are good that it’ll continue to outperform nearly every actively managed fund on Wall Street over the next 20 years.

All you need to do is buy an S&P 500 (SNPINDEX: ^GSPC) index fund, such as the Vanguard S&P 500 ETF (NYSEMKT: VOO), and you can expect to outperform most actively managed mutual funds.

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S&P Global publishes its SPIVA (S&P Index Versus Active) Scorecard twice per year. SPIVA compares the performance of actively managed mutual funds (after fees) to their relevant S&P benchmark indexes. Domestic large-cap funds are compared to the S&P 500, and their track record over the last 20 years is uninspiring.

Just 8.2% of large-cap domestic mutual funds outperformed the S&P 500 over the past 20 years. The odds are better over shorter time horizons, but ultimately the index seems to have a clear advantage. Here’s the percentage of domestic large-cap mutual funds that outperformed the benchmark over the various time horizons documented by SPIVA.

Period	1-Year	5-Year	10-Year	15-Year	20-Year
Percent Outperforming	43%	22.7%	15.3%	10.5%	8.2%

Data source: S&P Global SPIVA. Data as of June 30, 2024.

There are a few reasons for the dismal performance of actively managed mutual funds.

First, it’s important to understand the mechanics of the stock market. For every buyer, there must be a seller, and vice versa. The vast majority of market activity comes from institutional investors like mutual fund managers. So, when a professional fund manager decides to buy or sell a stock, there’s usually another professional manager on the other side of the trade. They can’t both come out ahead on the transaction.

In other words, when you aggregate the performance of all professional fund managers, their returns should look very similar to the overall index. That makes the odds of a single fund outperforming in any given year about 50/50.

Over time, however, fees will eat into every fund’s returns. That significantly reduces the odds of outperformance.

The most common fee for mutual funds is an expense ratio. That fee automatically comes out of the assets under management in the fund to pay the manager and the mutual fund company for its services. Actively managed funds commonly charge an expense ratio above 0.5%, some even charging over 1%. While that might not sound like a big drag on returns, it adds up over the long run. It shows up in the mere fact that just 43% of funds outperformed the benchmark index after fees over the past year.

The last reason that outperforming over the long run is so difficult is because a fund’s success makes it more difficult for it to continue having success. When a fund outperforms, it attracts more capital. With more assets under management, the fund manager may have to extend its investments to less desirable securities. Some smaller investments may no longer have as big an effect on the fund’s total returns as they did when the total portfolio was smaller.

As fund managers take on more assets and extend their investments into second- and third-tier investment choices, the odds of underperformance increase. That makes it that much harder to consistently outperform the market year after year.

An investment strategy that aims to match the returns of the overall market is a surprisingly strong performer relative to most actively managed mutual funds. That’s exactly what you’ll get if you invest in the Vanguard S&P 500 ETF.

The strategy avoids the pitfalls that lead actively managed funds to underperform over the long run. It effectively produces the same returns as the average fund manager. That is, its returns more or less match the S&P 500. But it does so with much lower fees. The ETF charges just 0.03% of assets under management for investors.

It also avoids the challenges presented to fund managers as they take on more assets, because it doesn’t make any active investment decisions. It simply buys every stock in the index in proportion to their weighting, ensuring its annual results are consistent with the index’s returns regardless of the size of the fund.

The Vanguard fund does a very good job of tracking the index closely. It’s kept its tracking error very low, which means the value of the ETF is consistently very close to the value of the index it tracks. That’s important for an investor who wants to buy shares on a regular schedule over time. If the fund value varied widely from the benchmark index, your actual returns would end up being better or worse than the index based purely on the day you happened to invest.

There are several other low-cost S&P 500 index funds you could choose from. The Vanguard S&P 500 ETF stands out for its low fees and low tracking error. While it’s not as exciting as investing with the hot new Wall Street fund manager, the expected performance over the long run is much better.

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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. The Motley Fool has a disclosure policy.

You Can Outperform Nearly 92% of Professional Fund Managers by Using This Simple Investment Strategy was originally published by The Motley Fool

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