Over the years I’ve boiled down mindful investing into one sentence:

• Buy and hold for the long-term (10 years or more) a moderately diversified set of low-cost stock index funds.

That’s it.  And even though there’s a lot of evidence, analysis, critique, and philosophy to be found in the over 400,000 words I’ve published at Mindfully Investing, when it comes to action items, this one sentence sums it up pretty well.

Of course, if you take a mindful approach to investing, and life in general, you also know that you shouldn’t simply accept anything as true without conducting your own rational assessment.  So, for those who want to dive deeper, I can break down this sentence into three explanations with supporting evidence provided at these Mindfully Investing links:

1. Buy and hold stock funds for the long-term, because historical data indicate that the chances of losing inflation-adjusted money in broad stock funds after about 10 years are very low, while the same is not true of bonds or cash.
2. Moderately diversify stock fund holdings, because no one can consistently predict the future and it’s unwise to put all your eggs in one basket.
3. Use low-cost index funds, because picking individual stocks or trying to “beat the market” are losers’ games.

Regarding the third point, it’s been quite a while since I’ve written about the folly of trying to beat the market.  So, I thought it would be a good time to review and update evidence regarding the performance of so-called “active funds”, where professional managers try to pick a set of stocks in hopes of outperforming a market index or benchmark.  The most common examples of such market indices are the S&P 500 and the Dow Jones Industrial Average.  But there are hundreds of other indices that can be used as appropriate comparisons to almost any style of active fund management.

Scorecards and Barometers

Fortunately, it’s not very hard to track the performance of active fund managers because at least two organizations collect and publically report on active fund performance on a semi-annual basis.  The first such report is called the SPIVA Scorecard and is produced by S&P Dow Jones Indices.  The second report is called the Active/Passive Barometer and is produced by Morningstar.

Given these reports come out shortly after the beginning and mid-points of each year, I was originally thinking I’d wait to write about them until after the New Year.  But on the other hand, I’ve been reviewing these reports for many years, and the overall story changes very little with each new report.  So, I can almost guarantee that what I’m about to tell you will be fully supported by the next set of reports in early 2022.

Annual Performance

An easy way to start sifting through the stacks of data in these reports is to consider how active funds perform on an annual basis.  Here are two graphs showing the percentage of active stock funds that have underperformed their benchmarks for every year presented in the SPIVA and Morningstar reports for U.S. stock funds and global stock funds, respectively.

In a good year, 40% of actively managed stock funds underperform their benchmarks.  And in a bad year, as much as 85% of these funds underperform.  That’s certainly not a thrilling performance in either case.  But an investor might be able to pick an active fund that has about a coin flip’s chance of outperforming a similar index fund in the next full year.  So, it might seem like the returns of an active fund could outpace the returns of a similar index fund over the long term, assuming that the active fund avoids catastrophically underperforming in any given year.

Mult-Year Performance

However, if we look at the same performance metric extended over multiple years, it turns out that most of these active funds cannot consistently outperform over the long term.

The longer the timeframe used to assess active fund performance, the greater the percentage of active stock funds that underperform their benchmarks.

What’s going on here?  It turns out that although about half the funds might outperform their benchmark in any given year, the list of funds that achieve this feat changes from year to year.  As a result, if you stick with the same fund for multiple years, the chances that the fund will continue to stay above the benchmark become less and less.

For example, if you hold an active U.S. stock fund for 3 years, you likely only have a 30% chance of beating an index.  And if you hold that same fund for 10 years, your chances of beating the index fall to just 15%.  The performance of global active stock funds shows a similar pattern of dwindling performance over time.

Performance Persistence

The question of whether an active fund manager can outperform year after year is often referred to as performance “persistence”.  And S&P Dow Jones also publishes a “persistence scorecard”, where they examine exactly this question.  In their most compelling analysis of persistence, S&P Dow Jones tracks the percentage of active funds that remained in the top 25% (top quartile) of performers within a given fund category over five consecutive years.  This graph shows the percentage of active funds staying in the top quartile from 2016 through 2020 for five categories of U.S. funds.

Depending on the fund category, only 6% to 16% of active funds that were in the top quartile in 2016 remained in the top quartile in 2017.  And for each year after that, the persistence of top performers progressively dwindles to anywhere from 0% to 5%, depending on the fund category.

For active stock funds in the U.S. Large-Cap category, slightly less than 1% of managers remained in the top quartile for five straight years.  Let that stat sink in for a moment.  For every 100 U.S. Large-Cap active stock fund managers, only 1 of them was able to achieve persistently high relative performance for five straight years!

The Problem of Costs

There are two reasons most often cited for the continual inability of most active stock funds to beat their benchmarks.  The first reason is that picking individual stocks or a set of stocks that will perform well is hard.  As I’ve detailed before, studies regularly show that just a small fraction of all available stocks tend to perform well over time.  One study found that just 4% of all U.S. stocks accounted for all of the net wealth earned by investors in the U.S. stock market from 1926 to 2015.  Another study found that 80% of all U.S. stocks collectively generated a total return of zero from 1989 to 2015.

The second reason is that active fund managers charge you money for the privilege of holding their funds.  The fees are usually around 1% of your invested money per year, which doesn’t sound like a lot.  But if an active manager charges 1% per year, that means they have to consistently beat the benchmark return by more than 1% per year for your money to grow faster than a similar investment in an index fund.

Even if you imagine that your favorite active fund manager is some kind of supernatural stock picker, evidence strongly suggests that the erosive force of costs alone is enough to determine active fund performance.  For example, in this graph, I selected several categories of active stock and bond funds with their performance sorted into five low-cost to high-cost bins or “quintiles” using data from the Morningstar report.

Not every category of active funds shows such a clear pattern.  But these five widely used categories of funds exhibited an unmistakably consistent trend of progressively worse performance as fund costs rise.

And if we compare the lowest-cost quintile to the highest-cost quintile for every category of active fund studied by Morningstar, we can see that the lowest-cost funds collectively outperform the highest-cost funds in almost all cases, sometimes by huge margins, as shown in this graph.

So, investors in active funds pay more for worse performance.  And the more they pay, the worse that performance gets.

Conclusions

Investing with active funds seems worse than gambling.  Why would any rational person want to pay money to almost guarantee a lower return than is easily achievable from a virtually free¹ index fund?   I’ve pondered that question ever since I started this website, and I still can’t fathom a good answer.

Going back to the title of the post, how do you beat 99% of professional stock pickers?  You simply invest any amount in a low-cost U.S. Large-Cap stock index fund (for example, tickers VOO, SCHX, or FNILX²) and hold on to that investment for five straight years.  The performance and persistence statistics we’ve seen indicate that you’ll most likely have more money at the end of those five years than similar investments in the vast majority of actively managed funds in the same category.  And even better, your index fund’s relatively superior results will be more persistent than 99% of all U.S. Large-Cap active managers.  Game over.

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1 – In some cases, index funds are more than virtually free, they are completely free.  For example, Fidelity’s Zero Large Cap Index Fund (FNILX) has an expense ratio of 0%.  That’s not an advertisement or an endorsement—just an observation.

2 – Also not an advertisement or endorsement for any of these funds.