Standing as a thorn in the side of active management, Vanguard brought to market the first retail index mutual fund in 1976. That passively run S&P 500 clone wound up propelling the Malvern, Pa.-based asset manager into becoming an industry behemoth.
But it hasn't dropped anchor as an indexing pioneer. The fund developer has been aggressively expanding its presence in the very field it once fought so hard to reshape. Today, Vanguard markets itself as one of the largest active fund management shops in the world.
To those who remember those earlier years when a chorus of industry pundits roundly condemned the indexing advocacy of Vanguard founder John Bogle (who passed away in early 2019), this push deeper into active management might seem somewhat ironic. It's certainly true that Bogle started his firm in 1975 using a collection of active strategies. At the same time, Vanguard first found broad market traction as a provider of index funds.
When Bogle was running this ship, he used to speak a lot about the role of his fund company as a true champion of the common investor. As it launches more active funds, however, fund investors don't seem to be unjustified in wondering about Vanguard's basic approach to managing other people's money. After all, is Vanguard's active lineup considered as simply another revenue stream by its management? Or, does this firm's leadership actually believe these funds can produce significant alpha -- in other words, above average risk-adjusted results with consistency?
Given such a fundamental set of questions underlying Vanguard's active family of mutual funds, we've decided to put these investment vehicles under our microscope as part of IFA's ongoing series breaking down how stock and bond pickers are doing compared to their respective indexes. (You can review our past analysis by clicking any of the links below.) One universal conclusion from our research into active managers: On the whole, they've failed to deliver on the value proposition they profess, which is to reliably outperform a risk comparable benchmark.
Controlling for Survivorship Bias
It is important for investors to understand the idea of survivorship bias, especially when examining Vanguard's stable of active funds.
First, let's start with the basics. This study's universe includes 57 active strategies offered by Vanguard with at least five years of performance data through 2018. Although we use Morningstar's classification system as reference, the authors don't consider Vanguard's passive target-date retirement series or its LifeStrategy family as actively managed funds. As a result, both of these types of funds are excluded from this analysis.
While some 57 active strategies with five or more years are studied, that doesn't necessarily mean these are the only active funds that this company has ever managed. In fact, we found 17 active funds that no longer exist. This could be for a variety of reasons -- including poor performance or the fact that they were merged with another fund. We will show what their aggregate performance looked like shortly, using the oldest share classes to measure each active mutual fund.
Fees & Expenses
Let's first examine the costs associated with Vanguard's surviving 57 active strategies. It should go without saying that if investors are paying a premium for investment "expertise," then they should be receiving above-average results consistently over time. The alternative would be to simply accept a market's return, less a significantly lower fee, via an index fund.
The costs we study with any fund family include expense ratios as well as front end (A), level (B) and deferred (C) loads, along with 12b-1 fees. (Of course, Vanguard's active funds are sold without such sales loads.) Together, these are considered the "hard" costs that investors incur.
Prospectuses, however, don't reflect the trading costs associated with mutual funds. Commissions and market impact costs are real expenses associated with implementing a particular investment strategy, and can vary depending on the frequency and size of the trades executed by portfolio managers.
We can estimate the costs associated with an investment strategy by looking at its annual turnover ratio. For example, a turnover ratio of 100% means that the portfolio manager turns over the entire portfolio in one year. This is considered an active approach and investors holding these funds in taxable accounts will likely incur a higher exposure to tax liabilities -- such as short- and long-term capital gains distributions -- than those incurred by passively managed funds.
The table below details the hard costs as well as the turnover ratio for all 57 surviving active funds offered by Vanguard that had at least five years of complete performance history through 2018. You can search this page for a symbol or name by using Control F in Windows or Command F on a Mac. Then click the link to see the Alpha Chart. Also, remember that this is what is considered an in-sample test; the next level of analysis is to do an out-of-sample test (for more information see here).
This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. For Vanguard funds, prospectuses are available at: https://personal.vanguard.com/us/literature/prospectus/mutualfunds
On average, an investor who utilized an active equity strategy from Vanguard at the end of 2018 experienced a 0.35% expense ratio. (Again, we're using the oldest share class for each fund.) Similarly, an investor who utilized an active bond strategy from Vanguard experienced a 0.18% expense ratio.
These expenses can have a substantial impact on an investor's overall accumulated wealth if they are not backed by superior performance. The average turnover ratios for equity and bond active strategies from Vanguard were 40.28% and 85.68%, respectively. This implies average holding periods of about 14.01 to 29.79 months.
In general, we find that Vanguard's active managers have made investment decisions based on relatively shorter-term outlooks, which means they've tended to trade more frequently in the past than a typical rival index fund. Again, this is a cost that is not itemized to the investor but is definitely embedded in the overall performance.
Performance Analysis
The next question we address is whether investors can expect superior performance in exchange for the higher costs associated with Vanguard's stable of active managers. We compare each of their 57 strategies from a fund's inception through 2018 -- which includes both current funds and funds no longer in existence (since inception with data through 2018) -- against its current Morningstar-assigned benchmark to see just how well each has delivered on their perceived value proposition.
We have included alpha charts for each of Vanguard's current strategies at the bottom of this article. Here is what we found:
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47.37% (27 of 57 funds) have underperformed their respective benchmarks or did not survive the period since inception.
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52.63% (30 of 57 funds) have outperformed their respective benchmarks since inception, having delivered a POSITIVE alpha.
So it's probably safe to say that investors in active mutual fund strategies offered by Vanguard have faced a roughly 50-50 percent chance of outperforming their Morningstar assigned benchmark or owning a fund that had survived over their lifetime.
Here's the kicker, however:
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3.51% (2 of 57 funds) outperformed their respective benchmarks, producing an alpha with a t-stat of 2 or greater since inception, providing a 97.5% level of confidence that such outperformance can be attributed to skill rather than luck.
In other words, of the strategies that delivered a positive alpha, just two produced enough consistency to yield a statistically significant result. The inclusion of statistical significance is key to this exercise as it indicates an outcome that's attributable to skill and potentially repeatable.
Regression Analysis
How we define or choose a benchmark is extremely important. If we relied solely on commercial indices assigned by Morningstar, then we may form a false conclusion that Vanguard has the "secret sauce" as an active management shop.
Since Morningstar is limited in terms of trying to fit the best commercial benchmark with each fund in existence, there is of course going to be some error in terms of matching up proper characteristics such as average market capitalization or average price-to-earnings ratio.
A better way of controlling these possible discrepancies is to run multiple regressions where we account for the known dimensions (betas) of expected return in the U.S. (i.e., market, size, relative price, etc.).
For example, if we were to look at all of the U.S.-based strategies from Vanguard that have been around for the past 10 years, we could run multiple regressions to see what each fund's alpha looks like -- once we control for the multiple betas that we know are being systematically priced into the overall market.
The chart below displays the average alpha and standard deviation of that alpha for the past 10 years ending 12/31/2018. Besides using common mathematical concepts of regression analysis, our methodology for this article incorporates a standard point of demarcation for determining the number of years reviewed. Given that many active families have few survivors with records spanning a decade or more, we use this number (10) for all managers studied as part of our ongoing Deeper Look series.
As you can see, the two funds that met the criteria didn't produce an alpha that was statistically significant at the 97.5% confidence level (green shaded area).
What we can say is that all active strategies from Vanguard do not have a statistically significant alpha once we control for their overall risk exposure. Why is this important? It means that if we wanted to simply replicate their risk exposure, we could do so more cost effectively through the use of index funds.
Given the lower costs associated with index funds, we could have more confidence that we will experience a more desirable result compared to more expensive actively managed funds.
Conclusion
Like many of the other financial institutions, a deep analysis into the performance of Vanguard has yielded a not so surprising result: active management is likely to fail many investors. We believe this is due to market efficiency, costs and increased competition in the financial services sector.
As we always like to remind investors, a more reliable investment strategy for capturing the returns of global markets is to buy, hold and rebalance a globally diversified portfolio of index funds.
Below are the individual alpha charts for the existing Vanguard funds that have five years or more of a track record. Note: When the alpha is negative, the result is negative years. Since this is a mathematical concept and not applicable in real-life, we denote "Minimum Track Record to Indicate Skill (t-stat>2)" in the following charts as N/A, or not applicable. Also, the years listed (by date) for each fund represent either its first full calendar year inception date or its benchmark's inception date. Generally, this is due to some funds providing data before its benchmark has reported information.
This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you. For more information about Index Funds Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.
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About the Authors
Murray Coleman - Investment Writer - Index Fund Advisors
Murray is an investment writer at Index Fund Advisors. Prior to joining IFA, he worked as a funds reporter for The Wall Street Journal, The Financial Times, Barron's and MarketWatch.
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.