Swedroe: Active Isn’t All Bad

October 19, 2018

Evidence From Vanguard’s Active Funds

In my Advisor Perspectives article of January 12, 2016, I studied the performance of Vanguard’s low-cost actively managed funds over the 15-year period ending September 2015, and found that Vanguard’s low-cost active funds had:

  • Outperformed Vanguard’s low-cost comparable index funds by an average of a 0.3 percentage point per year.
  • Underperformed the Dimensional Fund Advisors fund from the same asset class by -1.2 percentage points per year (mostly due to lower loadings on the aforementioned factors).
  • A four-factor alpha of 0.6% and a six-factor alpha (adding quality and low beta) of 0.1% per year.

The findings from Nanigian’s third test, using the paired funds, are consistent with findings from my study of Vanguard’s actively managed funds. When costs are comparable, active management doesn’t underperform.

His findings led Nanigian to conclude: “The practical implication of this study is that as long as investors are cost-conscious in their fund selection process, the active vs. passive choice is a moot point.” I suggest that this is not the right conclusion to draw, because it fails to consider several issues. For example:

  • Indexed strategies benchmarked to broad-market indexes provide greater control of the risk exposures in a portfolio—avoiding the problem of style-drift that can occur with active managers.
  • Index funds typically are more diversified than actively managed funds, reducing the dispersion of potential outcomes.
  • For taxable investors, index funds are typically more tax efficient due to their lower turnover.

Summary

There’s plenty of good news here for investors on both sides of the active versus passive debate. First, if you choose actively managed funds that have similar costs to index funds, on average, your returns should be similar. That’s because of the high degree of market efficiency, which greatly limits the ability of active managers to generate true alpha.

That same high level of efficiency also limits the possibility of them underperforming by much more than their total expenses (assuming they are broadly diversified).

Active investors can also benefit from using low-cost active funds that provide higher loadings on factors than do popular index funds. The same objective can be accomplished by using passively managed but nonindexed funds, as my firm does. (We use the structured portfolios of AQR, Bridgeway and Dimensional. Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR, Bridgeway and Dimensional Fund Advisors in constructing client portfolios.)

Second, competition is driving expense ratios down across the board, both for actively managed and passively managed funds.

Third, the cost of trading has come down greatly as commissions and bid-offered spreads have fallen sharply over the past several decades. Note that lower trading costs are best captured by those who can trade patiently and avoid the forced trading that index funds incur, and the market impact costs that actively managed funds incur if they are buyers of liquidity due to a perceived need to trade quickly in order to take advantage of “mispricings.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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