Investing Wisely: Outperforming Wall Street with Simplicity

Wall Street is home to some of the world’s most astute investors. Professional fund managers often possess high levels of education, dedication, and intelligence. It may seem daunting to outperform these finance experts.

However, you don’t need a highly intricate trading strategy to surpass 98% of professional mutual fund managers over time. You don’t have to devote endless hours to market analysis or news tracking. Interestingly, the less effort you invest, the more effective this strategy can be.

The most effective way to outshine the professionals is straightforward: invest in a broad index fund and hold it. This approach typically yields after-tax returns that outperform about 98% of actively managed mutual funds over the long term.

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The Challenge of Beating the Market

S&P Global releases the S&P Indexes Versus Active (SPIVA) Scorecard every six months. This report compares the performance of actively managed mutual funds against their S&P benchmark index over time. According to the latest SPIVA Scorecard, 90% of actively managed mutual funds have underperformed the S&P Composite 1500 index over the last decade.

Several factors contribute to this trend. Firstly, it’s crucial to understand that every stock trade involves a buyer and a seller. Since most trading volume comes from institutional investors, both sides of a trade are frequently represented by professional fund managers. Essentially, one manager’s gain is another’s loss, complicating the chances for consistent outperformance.

This scenario explains why the average return generated by professional fund managers aligns closely with market averages.

Moreover, as fund managers handle larger amounts of capital, the situation becomes more challenging. An investor could outperform the market while managing a smaller fund. Yet, generating high returns becomes trickier when significant capital is at stake. Consequently, attracting attention from investors can make it difficult to sustain strong performance over time.

Even Warren Buffett acknowledges these challenges. In his 1996 letter to Berkshire Hathaway shareholders, he commented that “an abundance of funds tends to dampen returns.” As the assets managed by Berkshire Hathaway have significantly increased over the past 28 years, it has become harder for Buffett to consistently outperform the market.

During an annual shareholder meeting in May, he remarked, “I would not want to manage $10 billion now – $10 million, I believe Charlie [Munger, his late partner] or I could earn high returns on.” Currently, Buffett oversees more than $600 billion in investable assets.

Fund managers face numerous hurdles from the beginning. Additionally, mutual fund companies charge fees to cover their operations and compensate managers. Therefore, fund managers must not only surpass the benchmark index but also outpace those fees. The data shows 90% do not succeed.

The Hidden Costs of Active Funds

Investing in an actively managed mutual fund entails another potential downside: taxes. These funds can produce taxable income for shareholders, which can significantly detract from investment performance.

Whenever you sell an investment, capital gains tax applies to any profits earned. Holding an investment for over one year grants a lower tax rate. Conversely, if held for a year or less, the gains are taxed at your income tax rate. Active mutual funds often generate capital gains with shorter holding periods, passing those gains on to shareholders.

S&P Global analyzed after-tax returns for actively managed funds in the SPIVA Scorecard using the highest marginal tax rates for both long-term capital gains and ordinary income. They also assessed the returns of their indexes, factoring in dividend distributions and possible capital gains from stock changes.

The analysis revealed that 98% of actively managed mutual funds failed to outperform the S&P 1500 over the previous decade, once factoring in taxes and fees. Even if focusing solely on large-cap funds competing against the S&P 500, the result remains 98%.

Investment Simplicity: The Key to Success

The findings are clear: given the many obstacles faced by professional fund managers, it’s improbable that you will find one who can consistently outperform the market index over time. This is why investing in an index fund is often a more strategic choice.

If you wish to align with S&P Global’s findings precisely, consider the SPDR Portfolio S&P 1500 Composite Stock Market ETF (NYSEMKT: SPTM). With an expense ratio of just 0.03% and a historically low tracking error, this ETF offers results closely aligned with the S&P 1500’s total return.

Another excellent option is the Vanguard Total Stock Market ETF (NYSEMKT: VTI). Unlike the S&P indexes, which require profitability, this fund may include some promising growth stocks that are not yet profitable. If you’re seeking exposure to earlier-stage companies, Vanguard Total Market could suit you well.

Alternatively, if your focus lies on large, profitable corporations, the Vanguard S&P 500 ETF (NYSEMKT: VOO) stands as a solid choice, boasting a low expense ratio and a strong history of aligning with its underlying index.

While some actively managed mutual funds may outperform the index funds in any given year, if you’re looking for superior returns over the next decade and beyond, these index funds are likely to be more favorable options.

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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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.