I am a big fan of Vanguard. I am an even bigger fan of its founder, John Bogle, who is no longer affiliated with the company. His book, The Little Book of Common Sense Investing, is a must read for all investors.
Bogle is a passionate advocate for indexing. I share his views. In my book, The Smartest Investment Book You’ll Ever Read, I recommended investing in three Vanguard index funds in an appropriate asset allocation. Following this approach has historically put investors in the top 5 percent of all professionally managed money.
The firm has long walked both sides of the street. While it continues to offer excellent, low management fee index funds and target retirement funds, where the underlying funds are all index funds, 44 percent of its fund line-up is in actively managed funds, where the fund manager attempts to beat a designated benchmark. Since these two approaches to investing are mutually exclusive, many people wonder how Vanguard could justify offering both approaches.
Vanguard responded to its critics in a paper titled: Active and index funds: No contradiction. Here’s the explanation offered by Gus Sauter, Vanguard’s chief investment officer: "I don't think the markets are completely efficient. They are reasonably efficient, but there are mispricings. While I think there's a very prudent argument for index investing, that argument doesn't rule out well-executed active management at a reasonable price. By keeping costs low, we believe we increase the chances that our active fund managers can outperform their benchmarks and their peer funds."
Fair enough. Sauter believes there are mispricings and his managers have a chance of finding them and outperforming the markets. If that were true, you would think Sauter would publish the methodology used by Vanguard’s fund managers to achieve this goal. Indeed, if it was possible to find these mispricings, why wouldn’t every Vanguard manager do so? And why wouldn’t Vanguard eliminate all of its index funds which simply track designated indexes?
How have Vanguard’s active fund managers done in their efforts to find these mispricings and beat the market? I looked at the twenty Vanguard actively managed stock funds that have at least ten years of returns data as of April 30, 2011. I compared them with corresponding index returns. I used the returns at vanguard.com as my source. I excluded balanced funds and funds that significantly changed their investment objective in the last ten years. An example of this type of fund is the Vanguard Dividend Growth Fund, which used to be the Utilities Income Fund. Here’s what I found:
- Only 40 percent of these funds (8 of 20) beat the index by a margin of 0.25 percent or greater. I tacked on the 0.25 percent to account for the approximate expense ratios of the funds.
- 15 percent of the funds (3 of 20) came within a 0.25 percent margin of the index. I regard that performance as a tie.
- 45 percent of the funds (9 of 20) lost to the index by a margin of 0.25 percent or higher.
Apparently, finding these perceived mispricings is really difficult.
The reality is there are no mispricings in the stock market. Millions of traders looking at all public information about stocks set the price and it is a fair price. Vanguard’s record is actually better than most actively managed funds. Over a ten year period, over 90 percent of them fail to equal or beat their designated benchmark.
The attempt by Sauter to justify having both active and passive funds in Vanguard’s offerings is somewhat disingenuous. If he had simply stated that most individual investors are either unaware of the data or choose to ignore it, and Vanguard does not want to miss out on the opportunity to profit from their business, that would have been more forthcoming. Attempting to justify active management on any other basis is inconsistent with hundreds of academic studies. The number of actively managed funds that equal or beat their benchmark is less than you would expect based on random chance. There is little persistency of outperformance. Trying to pick the next outperforming actively managed mutual fund is extremely difficult, if not impossible. It’s sad that John Bogle’s Vanguard is no more.
Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.
Corrected on 06/09/11: A previous version of this story misstated the percentage of actively managed funds and when they were first introduced. The current percentage is 44 percent and the company has sold actively managed funds since it was founded in 1975.