You can outperform 88% of professional fund managers using this simple investment strategy

Professional fund managers are responsible for investing billions of dollars for investors. They are often highly educated, have years of investment experience and are well paid for their skills and expertise. But the truth is, most are not worth the fees they charge.

It doesn’t require an advanced degree or special insider knowledge to outperform the vast majority of actively managed mutual funds. A simple strategy can defeat about 88% of them. It’s a strategy that Warren Buffett has bet half a million dollars on, hoping it can beat every hedge fund manager for 10 years.

He won the bet.

All you have to do is buy one S&P 500 index fund, such as Vanguard S&P 500 ETF (VOO -0.39%)and you can expect better long-term returns than most active mutual funds.

Why 88% of active large-cap funds can’t beat a simple index fund

S&P Global publishes SPIVA scorecards (S&P versus Active Indices) twice a year. The scorecard compares the performance of active mutual funds (after fees) with the respective S&P benchmark indices over periods of one, three, five, 10 and 15 years. It found that 88% of active large-cap funds failed to beat the S&P 500 over the past 15 years through the end of 2023. Even when looking at a shorter three-year period, about 80% failed to beat the benchmark.

There are several factors that lead to such dismal results for active funds as a group.

First, it is important to consider how the stock market works. There is always someone on both sides of a transaction; for every buyer, there is a seller. And among large-cap stocks, the people who buy and sell stocks are mostly institutional investors. In other words, a fund manager usually sells his shares to another fund manager. They cannot both be right.

Since large institutions make up the bulk of the market, the odds of outperforming the market as an active fund manager can only be slightly better than 50/50. But the second factor severely reduces the returns passed on to investors in actively managed funds.

Fund managers, their teams and the institutions they work for all seek compensation. This means that mutual fund investors have to pay fees. The most common fee is the expense ratio, which captures a portion of assets under management. These fees may increase above 1%. This means the fund manager has to outperform the market in the fee it charges clients just to break even. And that’s a lot harder than just beating the market by a few basis points.

As a result, the percentage of actively managed mutual funds that outperform the S&P 500 in any given year is only about 40%. And very few can consistently beat the market by enough each year to come out ahead in the long run.

Lower your “participation costs”.

If you want to outperform the average investor, the key is to reduce what Vanguard founder Jack Bogle called the “cost of participation.” These are the costs you have to pay to invest your money.

It’s gotten easier and cheaper to invest in the 25 years since Bogle coined that term. Portfolio transaction costs are close to zero with most brokerages waiving commissions on stock purchases. On average, expense ratios for mutual funds have also fallen significantly since the mid-1990s. However, an investor should aim to keep costs as low as possible, and this means avoiding unnecessary fees.

Since active mutual funds cannot exceed their fees, on average, these fees should be considered unnecessary. You can buy the Vanguard S&P 500 ETF and virtually match the market’s return for a fee of just 0.03%, or $3 for every $10,000 you invest.

And while it is true that some fund managers have exceeded their fees for a long time, identifying these funds in advance is not so simple. Furthermore, there’s no telling whether the results came from skill or luck, so you can’t be sure that the fund can continue its winning streak.

As a result, your best bet remains an S&P 500 index fund.

What makes the Vanguard S&P 500 ETF Buffett’s best choice?

In Buffett’s big bet against fund managers, he put his money in the Vanguard S&P 500 index fund. Berkshire Hathaway also owns a small amount of the S&P 500 ETF in its equity portfolio. There are several things that make it his top choice.

First, as mentioned, it has an expense ratio of 0.03%. This is one of the best in the industry.

Second, it has a very low tracking error. Tracking error tells you how closely (or widely) the ETF consistently tracks the index it’s compared to. This can make a big difference for someone investing in a regular schedule. You want the fund to mirror the index’s performance, so your results match the index’s results over the long term. It’s not worth sacrificing a low tracking error for a lower expense ratio, especially when the Vanguard fund is already so cheap.

There are many options to choose from, but the Vanguard S&P 500 ETF stands out as a top choice. It is a great option not only among other index funds, but among all large-cap stock funds.

Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends the Berkshire Hathaway, S&P Global and Vanguard S&P 500 ETFs. The Motley Fool has a disclosure policy.