Aim to Outshine Almost All Professional Mutual Fund Experts? Invest in This Single Asset and Maintain it Indefinitely.
Wall Street is home to some of the sharpest financiers globally. These professionals, often holding advanced degrees and working tirelessly, aim to outperform the market. However, it's not a complex trading strategy that guarantees beating more than 98% of these skillful investors long-term.
You don't need to dedicate all your free time to market studies, staying updated, and devising personalized buy/sell strategies. In fact, less involvement tends to boost the effectiveness of this straightforward strategy.
Your most profitable option to surpass pros is investing in a diversified index fund and holding onto it. Over the long term, this approach will generate better after-tax returns than about 98% of actively managed mutual funds.
Understanding why outperforming the market average is tough
S&P Global frequently releases a report titled S&P Indexes Versus Active (SPIVA) Scorecard, revealing the performance of actively managed mutual funds relative to their respective S&P benchmarks. The most recent analysis highlights that 90% of these funds underperformed the S&P Composite 1500 index over the previous decade.
Several factors contribute to this consistent underperformance. Firstly, keep in mind that every stock market transaction necessitates both a buyer and a seller. The majority of this trading volume stems from institutional investors, which means professionals are presiding over both sides of the deal. It's statistically improbable for both sides to be successful simultaneously.
This dynamic helps explain why the typical investment's returns with a professional fund manager may align with the market average. However, the challenge intensifies once the manager manages greater capital. While a clever investor might consistently outperform the market with smaller sums, managing larger capital becomes significantly harder.
Even Warren Buffett acknowledges this hurdle. In his 1996 letter to Berkshire Hathaway shareholders, he mentioned "an abundance of funds tends to dampen returns." As Berkshire's investable assets expanded over the last 28 years, Buffett has found it increasingly difficult to consistently surpass the market.
At Berkshire's annual shareholder meeting in 2022, he stated, "I wouldn't enjoy managing $10 billion now - I think Charlie [Munger, his late partner] or I could earn high returns with $10 million." Currently, Buffett oversees over $600 billion in investable assets.
So, fund managers face substantial odds right off the bat. But it's essential to recognize they aren't working without compensation. Mutual fund companies levy fees to cover manager salaries and personal earnings. Consequently, managers must surpass the benchmark index plus the fee percentage, which 90% of them fail to accomplish.
Don't overlook the significant tax burden
Investing in actively managed mutual funds involves a hidden tax burden that investors often overlook at their detriment. Active mutual funds are prone to generating taxable income for their shareholders, which can have a substantial impact on investment returns.
Whenever you sell an investment, you must pay taxes on any gains you earned from that investment, known as capital gains. If you hold the investment longer than a year, you'll benefit from a more advantageous tax rate. If you sell it within a year, you'll be taxed at the same rate as your regular income taxes. Active mutual funds tend to produce capital gains, and the holding period is often less than a year. These gains are then passed on to the shareholders.
S&P Global calculated the after-tax returns for the actively managed mutual funds in the SPIVA Scorecard by using the highest possible tax rates for both long-term capital gains and income. It also calculated the returns for its indexes with the same tax rates, taking into account dividend distributions and any potential capital gains from changes in constituent stocks.
The results demonstrated that 98% of actively managed mutual funds struggled to surpass the S&P 1500 over the previous decade when accounting for taxes and fees. If you only focus on large-cap funds aiming to beat the S&P 500, the figure remains at 98%.
The only investment strategy that outperforms professionals
The data leaves little room for doubt: given the numerous disadvantages faced by professional fund managers, it's highly improbable to select one that is likely to outperform the market index over the long term. That's why it's better to opt for an index fund.
If you wish to replicate S&P Global's findings in full detail, you might consider the SPDR Portfolio S&P 1500 Composite Stock Market ETF (SPTM 1.22%). This ETF boasts a low expense ratio of 0.03% and a historically minimal tracking error, providing investment results that closely mirror the S&P 1500's total return.
Consider the alternative of the Fidelity Total Market Index Fund (FIT 1.31%). Certain financial indices impose profitability standards that might exclude some of the top rising star companies. If having a minor stake in companies yet to turn a profit suits your preferences better, this Fidelity total market investment might be a more suitable selection.
Conversely, if you're more drawn to large, profit-making corporations, the Fidelity 500 Index Fund (FSPX 1.29%) is another excellent pick featuring a reduced expense ratio and a fantastic track record of closely following the underlying index.
Numerous actively managed mutual funds may outperform the following index funds in a single fiscal year. However, if you're an investor with a long-term horizons seeking the maximum returns amidst the following decade and more, these index funds typically outperform any actively managed fund available.
- To maximize your chances of outperforming professional investors in the long term, consider investing in a diversified index fund such as the SPDR Portfolio S&P 1500 Composite Stock Market ETF or the Fidelity Total Market Index Fund.
- In their 2022 annual shareholder meeting, Warren Buffett acknowledged that managing large sums of capital becomes significantly harder for professionals, even for himself, as it intensifies the challenge of consistently surpassing the market.
