Professional fund managers are extremely smart, highly educated, hard-working, and ultra-competitive. If you can perform in the top 2% of all professional fund managers on Wall Street, you're sure to find yourself with a very handsome payday at some point. Not to mention, you'll have proven to have the investment chops to take on more assets, earning more money in the future.
Surprisingly, it doesn't take all that much to come out ahead of 98% of professionals over the long run. You don't need a 160 IQ. You don't need an MBA or to work 80 hours a week studying the markets. And in an ironic twist, the less competitive you are, the better you'll be able to stick with a strategy that can lead you to after-tax returns that beat 98% of professionally managed mutual funds.
All you have to do is buy a broad-based index fund and hold it for years.
Image source: Getty Images.
Here's why it's so hard for the professionals to outperform the market
S&P Global publishes its SPIVA (S&P Indexes Versus Active) scorecard twice a year. The report details the performance of actively managed mutual funds relative to their closest S&P benchmark index over various periods of time. The most recent update found 90% of all domestic funds underperformed the S&P Composite 1500 index over the past 10 years.
The explanation is simple. Professional fund managers are operating in a two-sided market. For every fund manager that wants to buy shares of a stock, someone else must be willing to sell those shares. Due to the overwhelming amount of capital held and traded by institutional investors relative to small retail investors, the vast majority of the time the person on the other side of the trade is another professional. They can't both be right.
As a result, the average fund manager will produce returns very close to the market average.
But fund managers don't work for free and the companies they work for aren't non-profits. That's why mutual funds charge fees. And when you factor fees into the mix, it pushes the average fund manager well below the market average. Consistently outperforming a fund's fees over a 10-year period is an increasingly difficult challenge. That's seen in the fact that fewer and fewer actively managed mutual funds outperform the benchmark index (after fees) as more time goes on.
Another factor makes it even harder to outperform
If it weren't enough that the vast majority of active fund managers consistently fail to earn their fees, real life makes things even more complicated. In real life, investors have to pay taxes. And more often than not, active mutual funds are very tax-inefficient.
Whenever you sell an investment for a gain, you'll owe taxes on that gain. If you hold the investment for over one year, you'll get a preferred tax rate, but if you hold it for less than a year, you'll have to pay regular income tax on that gain. Active funds, by their nature, involve more short-term trading activity than might be desired by someone looking to keep their tax bill low. And the fund passes those taxable gains onto shareholders.
S&P Global calculated the after-tax returns of the actively managed funds it follows for the SPIVA scorecard using the highest marginal tax rates for both income and long-term capital gains. To maintain an apples-to-apples comparison, it also accounted for the drag of taxes on stock sales and dividend distributions from the S&P 1500 index. The result was another 8% of funds fell below the benchmark over the last 10 years.
Yes, 98% of professional fund managers failed to outperform the total market index after accounting for taxes.
Invest better than the best
The results of the study are clear: You can outperform almost every professionally managed mutual fund by simply buying and holding a total market index fund.
One of the best funds for tracking the S&P 1500 is the State Street SPDR Portfolio S&P 1500 Composite Stock Market ETF(NYSEMKT: SPTM). Its expense ratio of 0.03% is one of the best in the market and it does a good job of tracking the underlying index. As a result, you'll see returns roughly in line with the index that beats 98% of all domestic mutual funds.
What's more, the ETF has never made a capital gains distribution since its inception in 2000. Dividends distributed by the ETF are mostly taxed as qualified dividends. As such, you can keep your taxes extremely low by simply buying and holding the index fund.
Another option investors might consider is the Vanguard Total Stock Market ETF(NYSEMKT: VTI). It tracks an even broader index of over 3,600 U.S. stocks. It has the same expense ratio as the State Street fund, and Vanguard is well known for its ability to keep its tracking error low. It should produce comparable results to the State Street fund. Some investors may prefer the Vanguard name or the greater exposure to not-yet-profitable growth stocks you can find in the Vanguard fund.
Either way, sticking to a simple buy-and-hold strategy for a broad-based index fund will result in returns that are better (after fees and taxes) than almost all of the options to invest with the pros on Wall Street.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Total Stock Market ETF. The Motley Fool has a disclosure policy.
