What If Active Works?

March 01, 2006

Journalists are supposed to be unbiased. We're supposed to approach stories with a fresh mind, like scientists, and let the data drive the reporting. But here's a confession: I'm an indexer. And I approach things from an indexing perspective. I've studied the data forward and back, and I know that indexes generally beat actively managed funds over long periods of time.

So when I sat down to write an article about Vanguard's family of actively managed funds, I knew what I'd find: Vanguard's active funds would lag the indexes, pretty much across the board. There might be a few winning funds—hey, everyone gets lucky once in a while—but the index funds would emerge victorious. I even knew how I was going to title the article: "Vanguard Should Stick To Indexing."

But then a funny thing happened: The data got in the way. I compiled a list of all of Vanguard's active equity or mixed equity/fixed-income funds with at least a 10-year track record, and compared that 10-year performance to the most relevant benchmark (see the "A Note on Methodology" section that follows). Of the 20 active funds, 14 beat their benchmark.[1]

Then I looked at all the funds with at least a five-year track record, and I compared those funds to their benchmarks. Of the six active funds, four beat their benchmark.

That left the Vanguard Dividend Growth Fund, an actively managed fund that invests in high-yield equities.[2] The Dividend Growth Fund has been around for a while, but it significantly changed its focus in 2002, expanding from a Utilities fund into a broad-based, diversified high-yield fund. For all intents and purposes, that made it a new fund, meaning that Dividend Growth really only has a three-year track record.

How has it done? Well, over the past three years, it's trailed the Dow Jones Select Dividend Index by more than 2 percent per year, returning 14.25 percent against the benchmark's 16.86 percent.[3]


Ha!, I thought. Indexing wins! Take that, you pompous "think-I'm-smarter-than-everyone-else" active managers!

But I could only revel in the outperformance of the dividend index for so long. Eventually, the brutal reality set in: In general, Vanguard active funds were beating the pants off of their benchmarks.

I looked for the usual tricks active supporters use to make themselves look better than they really are. Had Vanguard simply shut down its underperforming active funds, skewing the remaining results? Not really: They merged a Technology fund into oblivion in 1994, and they liquidated a preferred stock fund in 2001, in large part because a change in the tax law made preferred stocks less appealing to corporate investors. But a fund here or there doesn't tip the balance.

Maybe, I thought, the outperformance only came in certain styles or sectors? After all, actively managed small-cap growth funds have long outperformed their indexes. But no, the outperformance was everywhere: It spread across size, style and sector (although sector funds did particularly well); it reached across oceans, with international funds posting especially large alphas; and it stretched across 10 tumultuous years for the markets, where dramatic moves and style shifts should have tempted active managers to chase returns.

What gives? How have Vanguard's active funds managed to avoid the curse of underperformance?

I turned to Joe Brennan, who heads the Portfolio Review Group at Vanguard, to find out.

"The way we think of it, the main reason active funds have lagged the market is expenses," says Brennan. "So we try to find the best firms to run our active money, and then we give those funds the advantage of low expenses. It gives them a head start."

A quick check of the data bears Joe out, at least partially. Whereas the average actively managed mutual fund charged its investors 1.14 percent in 2004, according to the Investment Company Institute, the most expensive Vanguard fund—the Vanguard Growth Equity Fund—charged "just" 88 basis points.[4] Moreover, the mean expense ratio for Vanguard's actively managed funds is 47.6 basis points, (the median is 46 basis points). Subtract 47 basis points from 1.14 percent and you see that the average Vanguard active fund starts out with a head start of about 67 basis points over the average actively managed fund. And that's before you add in the cost of loads, sales charges and redemption fees.

"We believe in low cost," says Brennan.

But low cost doesn't entirely explain it. Low costs might explain why Vanguard's funds do better than the average actively managed equity fund. After all, the research shows the average equity fund trails the market by about 1.5 percent per year, or about the same amount they charge investors in "all-in" expenses, adding in cash drag, turnover costs, etc. By that logic, Vanguard's actively managed funds should lag the market by just 46 or 47 basis points.

But that's not what the data show. The data show that Vanguard's active funds beat their unmanaged benchmarks, and beat them cleanly, over long periods of time.

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