Why Index Funds Often Outperform Professional Fund Managers

Professional fund managers are paid significant salaries to manage hundreds of billions of dollars for their investors. Their education and experience suggest they should be capable of delivering superior returns. However, evidence indicates that many fail to do so.

Despite their expertise, most professional fund managers struggle to generate returns that offset their high fees. Astonishingly, you don’t need advanced education to beat up to 92% of professional fund managers over time.

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Investing in an S&P 500 index fund, such as the Vanguard S&P 500 ETF (NYSEMKT: VOO), remains a simple strategy that has historically proven effective.

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Challenges of Beating the Market

S&P Global releases the SPIVA (S&P Indices Versus Active) Scorecard biannually. This report reveals how few actively managed mutual funds outperform their S&P benchmark. After accounting for survivorship bias, just over 8% of active large-cap U.S. equity Stock funds have bested the S&P 500 over the past 20 years.

Several factors contribute to the difficulty of outperforming the broader market, even for skilled professionals.

Primarily, the stock market, especially large-cap stocks, is heavily influenced by institutional investors such as active mutual fund managers. Approximately 80% of transactions in large-cap stocks are executed by these institutions, meaning that the prices are largely set by their buying and selling decisions.

As a result, active fund managers are competing against each other to uncover value. This competition can quickly diminish any advantages they may initially hold, making the odds of outperforming approximately 50/50.

Active managers also face a challenge known as the paradox of skill, as articulated by Michael Mauboussin, head of Consilient Research at Counterpoint Global. When skill levels rise consistently among managers, chance becomes a more significant determiner of success. For instance, in a hypothetical scenario, two closely matched professional tennis players may have their match decided by a single unpredictable bounce.

Active fund managers must not only achieve market outperformance but do so sufficiently to cover their fees.

The Insights of Jack Bogle and Warren Buffett

In a 1997 address, Jack Bogle, founder of Vanguard, shared a fundamental insight: “Investors as a group cannot outperform the market, because they are the market.” He went further to state that, due to participation costs, investors as a collective must underperform the market.

Warren Buffett illustrated similar points in his narrative about the Gotrock family. This family owned shares in all American companies but ended up losing their wealth when they hired financial managers in a quest to outperform each other. Had the Gotrocks retained their original investments, they would have accrued substantially more wealth over time.

Reducing costs is crucial for long-term investment success. Many actively managed funds come with high expense ratios, especially in comparison to index funds. The Vanguard S&P 500 ETF has a notably low expense ratio of just 0.03%, making it an attractive option.

Identifying fund managers who can consistently outperform is a daunting task. Successful managers often draw significant attention and capital, leading them to invest their growing pools in less promising opportunities, which can further increase the unpredictable nature of their returns. Consequently, prolonged outperformance often leads to challenges as managers expand their portfolios.

In contrast, index funds replicate their respective benchmarks and benefit from lower investment costs. A well-performing index fund can surpass most actively managed mutual funds over time due to its low “cost of participation” and straightforward objective of matching market returns.

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Adam Levy holds no positions in any 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.

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