Want to outperform 88% of professional fund managers? Use this simple investment strategy.

Becoming a professional fund manager isn’t easy, but beating the returns of some of the world’s best fund managers turns out to be, too. It’s a quirk of stock market mechanics that makes a simple investment strategy far better than an actively managed mutual fund. While it may be possible for many professional funds to outperform in the short term, it becomes increasingly difficult as time goes on.

There is a heavy weight to the return on investment of active funds: fees. As a result, only 12% of active mutual funds outperformed S&P 500 the index of the last 15 years, according to S&P Globalhis SPIVA scorecard. Spotting that 12% of the time is virtually impossible, so the best strategy to beat professional fund managers is to buy a simple S&P 500 index fund like Vanguard S&P 500 ETF (VOO 0.94%).

It won’t turn heads when you mention it at your next dinner party, but it offers one of the highest expected returns of any investment you can buy. And it will do much better than an actively managed mutual fund picked at random.

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Why it’s so hard for professionals to outperform

In general, institutional investors account for the vast majority of trading volume, particularly among large-cap stocks. Institutional investors typically account for 85% of trading volume. Individual investors are not nearly as active in the market and hold much less capital.

In other words, professionals as a group are highly representative of the entire market. As such, the average professional investor should only expect to produce returns in line with general market returns.

The problem of underperformance arises because professional fund managers charge high fees for their services. These fees come in the form of expense ratios and fund loads. The average expense ratio for an actively managed mutual fund was 1.01% last year.

A 1% reduction in average ROI leads to significant performance over time. That’s why the SPIVA scorecard shows that over 40% of fund managers have outperformed in the past year, but only 12% have outperformed over the past 15 years.

Yes, there are fund managers who can consistently outperform the index most years, earning their fees. However, it is difficult to determine in advance who these fund managers are. Basing an investment decision on past performance rarely works. Of the large-cap funds that were in the top quartile of performers in 2019, none remained in the top quartile over the next four years. In fact, the fund’s performance is less persistent than expected under the random distribution.

Reduce the cost of market participation

Several investors have laid out the keys to successful investing, but by far one of the biggest factors is controlling the cost of participation. Vanguard founder Jack Bogle coined the idea of ​​the cost-weighting hypothesis: “The gross return on the financial market minus the costs of financial intermediation equals the net return actually delivered to investors.”

Warren Buffett echoes the idea in his 2005 letter to shareholders, where he recounts the parable of the Gotrocks. The family once owned every American corporation, but have seen their fortunes destroyed by “helpers” who promise to help individual family members outdo their relatives for just a pittance. He concluded with a simple analogy to Newton’s laws of motion: “For investors as a whole, returns decrease as motion increases.”

The easiest way to reduce the movement and keep the help fees low is to buy an index fund. The Vanguard S&P 500 ETF has an expense ratio of just 0.03% and extremely low tracking error. It trades only when changes are made to the S&P 500 index each quarter and rarely produces a taxable event for its shareholders. The results are net returns that are extremely close to the gross returns of the components of the S&P 500 Index.

While a hot, actively managed mutual fund and a star fund manager may seem attractive, digging into the data suggests it’s probably not a smart investment. On average, you’ll do much better if you focus on the fund with the lowest fees over the past year, rather than the best performing fund.