Professional fund managers get paid a lot of money to invest hundreds of billions of dollars for their investors. On the surface, there are good reasons to trust these pros with all that money: They’re highly educated and have developed significant expertise over the years. That should give them a significant advantage when it comes to generating outsized returns.
But the truth is most professional fund managers fail to earn enough for their investors to make up for the high fees they charge. You don’t need any advanced education or special insights in the market to outperform up to 92% of professional fund managers over the long run.
All you need to do is buy an S&P 500 index fund, such as the Vanguard S&P 500 ETF(NYSEMKT: VOO), and hold it forever.
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S&P Global publishes its SPIVA (S&P Indices Versus Active) Scorecard twice per year, detailing how many actively managed mutual funds outperform their respective S&P benchmark index. It corrects for factors like survivorship bias, which would skew active fund performance higher. And as a result, it found just over 8% of active large-cap U.S. equity stock funds have outperformed the S&P 500 over the last 20 years.
There are several reasons why beating the market, even for these seasoned professionals, is really hard.
First, consider that the stock market, particularly large-cap stocks, is dominated by institutional investors like those managing active mutual funds. Roughly 80% of the volume in large-cap stocks comes from institutional investors. That means the price of a highly-traded stock is largely dictated by those professionals.
In other words, active fund managers are working against other active fund managers to find value and outperform the broader market. The result is that any advantages they may have quickly evaporate, leaving the odds of outperforming somewhere around 50/50.
Active management also suffers from what Michael Mauboussin, author and head of Consilient Research at Counterpoint Global in New York, calls the paradox of skill. When skill is very high and consistent across the field, luck plays a much bigger role in determining which managers outperform. Imagine two equally matched pro tennis players trying to win a point; one weird bounce on the court or a strong breeze could end up determining the winner.
But active managers don’t just have to get lucky enough to outperform the market, they have to outperform the market by enough to justify their fee.
In a 1997 speech, Jack Bogle, the founder of Vanguard, laid out a very simple theory: “Investors as a group cannot outperform the market, because they are the market,” he said. In fact, he took that a step further by saying investors, as a group, must underperform the market “because of the costs of participation.” Those costs include things like transaction costs, administrative fees, and the expense ratio on your mutual funds.
Warren Buffett spoke of those same challenges for investors in his parable of the Gotrock family. The family once owned every American corporation but lost it all as individual members hired “helpers” like brokers, managers, and financial advisors to help them grow their wealth faster than other family members. If the Gotrocks had simply maintained their ownership of everything, they would have come away with far more wealth in the long run.
Reducing your cost of participation is paramount to long-term success in investing. Many actively managed mutual funds have high expense ratios, especially when compared to index funds. The Vanguard S&P 500 ETF sports an expense ratio of just 0.03%. It’s hard to find anything less expensive than that.
While there are fund managers who can outperform their fees for an extended period of time, identifying them beforehand is practically impossible. What’s more, successful managers tend to attract attention and the capital that comes along with it. At the very least, their successful investments produce a ton of capital they must eventually redeploy. With more capital to invest, the fund manager must extend their portfolio to less promising investments, increasing the role of luck in outperformance. As a result, strong outperformance often leads a smart and successful manager to become less successful (but no less smart) over the long run.
That challenge will never plague an index fund, which simply matches the benchmark it’s designed to track. An index fund with a strong record of closely tracking the returns of the index it follows is an excellent investment for most individuals. With a low “cost of participation” and a simple expectation of matching the market, it can outperform the vast majority of actively managed mutual funds over the long run.
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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.
Want to Outperform Nearly 92% of Professional Fund Managers? Buy This 1 Investment and Hold It Forever. was originally published by The Motley Fool
