“Data! Data! Data!” he cried impatiently. “I can’t make bricks without clay.”
— Sir Arthur Conan Doyle,“The Adventure of the Copper Beeches”¹
As a financial advisor, you should not need to play detective to identify the best investment vehicles for your clients. You should, however, consider the details of potential holdings—the data, in Sherlock Holmes’ terms—recognizing that fund names often don’t tell us everything we ought to know.
Active-passive line has blurred
It was never a good idea to choose funds on the sole basis of their names. Today, however, the risk of that approach leading you to a fund that does not operate as you might expect may be greater than ever. That’s true, in part, because the line between actively managed and index funds has blurred. Hundreds of ETFs and “smart beta” funds have been introduced in the twenty-first century.
While many ETFs are traditional market-capitalization-weighted index funds, other ETFs—and all the so-called smart beta funds—are not. Their intention is to outperform the markets or market segments in which they invest, though many of them have index in their names. Tellingly, some of these funds carry significantly higher expense ratios than market-cap-weighted index funds.
While part of the haze that’s settled over the active-index debate may be organic—the natural result of asset managers’ efforts to meet investor needs by expanding product offerings—I suspect much of it owes to conscious efforts to cloak higher-cost actively managed offerings under the secularly trendy banner of indexing. The solution is straightforward, if more labor-intensive than simply looking at fund names: We should evaluate funds—actively managed and index alike—on the basis of their costs and managerial talent.
Low-cost active funds can outperform the average index fund
While Vanguard is often discussed as an “index shop,” we have always believed in active management. Indeed, as of March 31, 2016, more than $1 trillion of our assets under management worldwide was invested in actively managed funds. So it should not be too surprising to read that I believe:
Consider the bar chart below. It shows that actively managed Vanguard U.S. equity funds have an average expense ratio of 34 basis points (0.34%). The average U.S. equity index fund and ETF, excluding Vanguard funds, charge roughly 2.3 and 1.3 times as much—78 and 43 basis points, respectively. The same pattern appears in the international equity and taxable bond categories, among others.
The results, as they say, speak for themselves. For periods ended December 31, 2015, the percentages of Vanguard active funds whose returns beat their peer-group averages were 89% for one year, 93% for three years, 90% for five years, and 97% for ten years.²
Cost and managerial talent are what matter
Indexing used to refer to low-cost, broadly diversified, market-capitalization-weighted portfolios. Actively managed portfolios could be defined as carrying higher costs, with less diversification and more risk. Today, it is overly simplistic to say that “indexing outperforms active management,” or that index funds are “low-cost” or “broadly diversified.”
You should consider the source, of course—looking under the hoods of funds and drawing your own conclusions—but I believe that Vanguard’s actively managed funds offer not only low costs but high-quality management teams. And that is what advisors and investors should seek from any asset manager, no matter the funds’ labels.
1 Sir Arthur Conan Doyle, 1892. Adventure 12: “The Adventure of the Copper Beeches.” The Adventures of Sherlock Holmes. London: George Newnes Ltd.
2 For the one-year period, 10 of 10 money market funds, 40 of 44 bond funds, 19 of 22 balanced funds, and 41 of 47 stock funds, or 110 of 123 Vanguard funds outperformed their peer-group averages. For the three-year period, 10 of 10 money market funds, 41 of 44 bond funds, 20 of 22 balanced funds, and 42 of 45 stock funds, or 113 of 121 Vanguard funds outperformed their peer-group averages. For the five-year period, 10 of 10 money market funds, 38 of 44 bond funds, 19 of 21 balanced funds, and 41 of 45 stock funds, or 108 of 120 Vanguard funds outperformed their peer-group averages. For the ten-year period, 10 of 10 money market funds, 42 of 44 bond funds, 14 of 14 balanced funds, and 38 of 39 stock funds, or 104 of 107 Vanguard funds outperformed their peer-group averages. Results will vary for other time periods. Only funds with a minimum one-, three-, five-, or ten-year history, respectively, were included in the comparison. Source: Lipper, a Thomson Reuters Company. Note that the competitive performance data shown represent past performance, which is not a guarantee of future results, and that all investments are subject to risks. For the most recent performance, visit our website at vanguard.com/performance.
- Past performance is no guarantee of future results.
- All investing is subject to risk, including possible loss of principal.