This simple investment strategy will help you outperform 88% of professional fund managers

Professional fund managers are responsible for investing billions of dollars for investors. They are often highly educated, have years of investment experience, and are well compensated for their skills and expertise. But in reality, most don’t get the value of the fees they charge.

You don’t need an advanced degree or special inside information to outperform most actively managed mutual funds — you can beat about 88% of them with a simple strategy, like the one Warren Buffett famously bet $500,000 on in the hopes of beating every hedge fund manager over the course of a decade.

He won the bet.

What you need is: S&P 500 Index funds, for example Vanguard S&P 500 ETF (VOO -0.39%)it offers the potential for better long-term returns than most actively managed mutual funds.

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Why 88% of active large-cap funds fail to beat simple index funds

S&P Global The firm publishes its SPIVA (S&P Index vs. Active) scorecard twice a year. The scorecard compares the performance (net of fees) of active mutual funds to the relevant S&P benchmark index over one-, three-, five-, 10-, and 15-year periods. It finds that as of the end of 2023, 88% of active large-cap funds have failed to beat the S&P 500 over the past 15 years. Even over the shorter three-year period, about 80% have failed to beat their benchmarks.

There are several factors that could lead to such dismal results for active funds as a whole.

First, it’s important to consider how the stock market works. There is always someone on both sides of a trade. That is, as long as there are buyers, there are sellers. And in the case of large cap stocks, the people buying and selling stocks are mostly institutions. In other words, it’s usually one fund manager selling stocks to another fund manager. They can’t both be right.

Because the market is largely made up of large institutional investors, your chances of beating 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 compensation, which means mutual fund investors have to pay fees. The most common fee is the expense ratio, which is a percentage of assets under management. This fee can be well over 1%. This means that to break even, fund managers have to outperform the market by the amount of fees they charge their clients. And that’s much harder than simply beating the market by a few basis points.

As a result, only around 40% of actively managed mutual funds outperform the S&P 500 in any given year, and only a very small number of mutual funds outperform the market consistently year after year to give them an advantage over the long term.

Reduce the “cost of participation”

If you want to outperform the average investor, the key is to reduce what Vanguard founder Jack Bogle calls your “cost of participation” — the cost you have to pay to invest your money.

In the 25 years since Bogle coined the term, investing has become easier and cheaper. Portfolio trading costs are close to zero, as most brokerages waive commissions on stock purchases. On average, mutual fund expense ratios have also fallen significantly since the mid-90s. Still, investors should aim to keep costs as low as possible, and that means avoiding unnecessary fees.

Since active mutual funds, on average, cannot outperform their fees, fees should be considered unnecessary.By purchasing the Vanguard S&P 500 ETF, you can earn returns that essentially match the market return for just 0.03% fees, or $3 for every $10,000 invested.

While it’s true that some fund managers do beat their fees over the long term, it’s not that easy to identify such funds in advance, and you can’t tell whether their results are down to skill or luck, so you can’t be sure that a fund will continue to win.

As a result, the best option remains an S&P 500 index fund.

Why is the Vanguard S&P 500 ETF Buffett’s favorite?

In a big bet against fund managers, Buffett put his money into the Vanguard S&P 500 index fund. Berkshire Hathaway He also holds a small amount of the S&P 500 ETF in his stock portfolio. This ETF is his favorite for a few reasons.

First, as mentioned above, the expense ratio is 0.03%, which is among the highest in the industry.

Second, it has a very low tracking error. Tracking error indicates how consistently close (or broad) an ETF is to its benchmark index. This makes a big difference for people who invest regularly. You want your fund to mirror the performance of the index so that over the long term, your results match those of the index. It’s not worth sacrificing low tracking error for a low expense ratio, especially when Vanguard funds are already so inexpensive.

There are plenty of options to choose from, but the Vanguard S&P 500 ETF stands out as a top choice — not just among other index funds, but among all large-cap funds.