Vanguard: Active Funds Can Outperform Passive
January 11, 2013
"If the data do not prove that indexing wins, well, the data are wrong."
John Bogle, founder, Vanguard Group "Little Book of Common Sense Investing," p. 28
For the most part, the data appear to be true.
In statistics compiled for Money Management Executive by Morningstar, passively managed stock funds-those that do no more than match the component stocks found in an underlying index-achieved a 9.45% annual return over 25 years. That edged the annualized returns of actively managed stock funds (9.42%) and easily beat actively managed mutual funds of all types (7.89%). Passively managed mutual funds of all types came in at 9.08%.
Similarly, passively managed exchange-traded funds achieved the best annual returns over the last 15 years (6.19%) and last 10 years (8.96%).
But, after that, the data can be "wrong." Actively managed stock funds had the best performance over 20 years, edging passive stock funds 8.14% to 8.11%. And actively managed mutual funds of all types have done the best in the last five years, coming in at 1.98% where, for instance, passively managed exchange-traded funds lost 1.17% a year.
Which just goes to show, when it comes to investing, active management versus passive management "is not an either-or" proposition, said Russ Koesterich, chief investment strategist for BlackRock, the world's largest asset manager. "It's both.''
And, as if to prove the point, Vanguard Group, the company that became the largest mutual fund firm in the world from promoting the virtues of index investing, actually agrees.
In a research report posted on Jan. 8 to its website, Vanguard says "most actively managed equity funds will underpform their benchmarks.'' But it argues that there are "concrete ways of increasing the probability of success" with active management.
"On average, actively managed funds will not outperform'' the index against which they gauge their success, said Daniel Wallick, a principal in Vanguard's Investment Strategy Group and a co-author of the report. "But a subset will.''
And, perhaps not surprisingly, that subset includes funds actively run by Vanguard managers.
Many Vanguard investors, he notes, don't even know that the firm has actively managed funds. But Vanguard got its start handling administrative functions for an operator of active funds known as Wellington Management.
When Bogle in 1974 founded Vanguard, he started with active funds. Then, in 1976, the firm launched the Vanguard 500 Index Fund, the first index-based mutual fund.
Now, the company has $2 trillion in assets under management, with $1 trillion, roughly, in index funds. But it also has $850 billion placed in actively managed funds. For the last three decades, Vanguard has operated 34 such funds, ranging from a Dividend Growth fund to a Global Equity fund.
As with its passive funds, Vanguard pushes to keep costs down. It believes the expense ratio is a key indicator of the success of active funds. The lower the expenses, the greater the return.
A couple ways it keeps those costs down is by operating as a company owned by its funds and by dishing out large chunks of assets to subadvisors to manage. By dishing out large amounts of money to manage, it can keep management fees down.
Here's how it works. A subadvisor gets a billion dollars or more to manage. It gets a base fee that is a percentage of the assets managed. Then, the manager gets an incentive fee.
If the manager outperforms the fund's benchmark, the manager gets paid a bonus. But, underperformance results in a penalty. Long-term thinking is encouraged by basing each year's incentive calculation on either three- or five-years of results.
Over a 15-year period, that has meant that Vanguard's active funds have produced one-half of a percent of excess return, above their benchmarks. By contrast, according to the report authored by Wallick and certified financial advisors Brian Wimmer and James Martiolli, all other active funds combined have underperformed their benchmarks by one-third of a percent. So the swing is 84% of one percent.
All told, over a 30-year period, the active funds have produced "excess return" above their benchmarks of $27 billion and a total of $191 billion of value for their shareholders.
Vanguard's active funds even outperform 40% of passive funds, Wallick says. The key is finding the right managers. That is handled by 20 professionals, led by CEO William McNabb. Performance matters, but what gets judged is the person, the portfolio and the philosophy, as well.
"It's not just a checklist. It's not just a quantitative exercise, where you run three filters and you've identified the winners,'' said Wallick. "There's a highly qualitative part."
Over time, as the Morningstar numbers indicate, though, actively managed and passively managed funds can have nearly the same results.
But that's because the results of large numbers of active or passive funds are blended together, says Selwyn Gerber, an asset manager in Los Angeles at RVW Investing.