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 proudly tout his fund company's mission to serve as a true champion of the common investor. These days, however, it's not unusual for us to hear questions about whether Vanguard's current management considers an expanding number of active fund launches as simply another revenue stream.
Perhaps an even more pointed question by those who prize Bogle's fiduciary insights: Does this firm's current leadership actually believe that actively managed funds can produce alpha with any degree of statistical signficiance — and consistency — over time?
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. 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's important for investors to understand the idea of survivorship bias. First, let's start with the basics. This study's universe includes 66 active strategies with at least five years of performance data currently offered by Vanguard. Although our research references Morningstar's independent classification system to analyze individual funds, we 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 there are 66 active equity mutual funds with five or more years of performance-related data offered by Vanguard, it doesn't necessarily mean these are the only strategies this company has ever managed. In fact, there are 22 stock mutual funds with five-plus years of data that no longer exist. This can 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 looks like shortly.
Fees & Expenses
Let's first examine the costs associated with Vanguard's surviving 66 equity 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 examine include expense ratios, sales loads — front-end (A), back-end (B) and level (C) — as well as 12b-1 marketing fees. These are considered the "hard" costs that investors incur. Prospectuses, however, do not 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 66 surviving active stock funds offered by Vanguard that have at least five years of complete performance history. (The funds are listed by oldest share class.) 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).
On average, an investor who utilized a surviving Vanguard active equity mutual fund strategy experienced an annual expense ratio of 0.34%. Similarly, an investor who utilized an active bond strategy from Vanguard experienced an expense ratio of 0.18% per year. (Again, we're referencing each fund's oldest share class.)
These expenses can have a substantial impact on an investor's overall accumulated wealth if not backed by superior performance. The average turnover ratios for surviving stock and bond active funds from Vanguard were 35.70% and 150%, respectively. This implies average holding periods of about eight to 33.61 months.
By contrast, most index funds have very long holding periods — decades, in fact, thus deafening themselves to the random noise that accompanies short-term market movements and focusing instead on the long-term. Turnover 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 implementation of active management. We compare all of its 88 strategies with data for five or more years against its Morningstar assigned benchmark to see just how well each has delivered on their perceived value proposition. Note: In some cases, the oldest share classes of a fund pre-date the benchmark. In those cases, comparisons can only be made for the length of time that the benchmark has data available.
We have included alpha charts for each of their current strategies at the bottom of this article. Here is what we found:
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60.23% (53 of 88) of these Vanguard funds run by active managers either didn't survive or underperformed their respective benchmarks since inception.
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39.77% (35 of 88) of Vanguard's actively managed funds outperformed their respective benchmarks since inception by producing a positive alpha.
Here's the real kicker, however:
- 5.68% (5 of 88) of Vanguard's actively managed funds wound up outperforming their respective benchmarks consistently enough (since inception) to provide 97.5% confidence that such outperformance could persist (as opposed to being based simply on random outcomes).
So, relatively few — less than 6% — of Vanguard's active managers were able to deliver statistically significant benchmark outperformance. The inclusion of the statistical significance of alpha is key to this exercise, as it indicates which outcomes are due to a skill that is likely to repeat and those that are more likely due to a random-chance outcome.
Such a finding supports other Deeper Look studies we've conducted looking at different fund families and active managers.
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 through 2021. Besides using common mathematical concepts of regression analysis, our methodology for this study 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) as a basic threshold for comparing active managers as part of our ongoing Deeper Look series.
As you can see, the four mutual funds that met the criteria didn't produce an alpha that was statistically significant at the 97.5% confidence level (green shaded area).
Such an analysis tells us that once we statistically control for a manager's risk exposure in this period, none of Vanguard's active mutual funds produced a statistically significant alpha. Why is this important? It means that if we wanted to simply replicate the factor risk exposures of these Vanguard funds with indexes of the factors, we could blend the indexes and capture similar returns.
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 large active managers, a deep analysis into the performance of the Vanguard family of funds has yielded a not so surprising result: Active management is likely to fail many investors. 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 Vanguard's actively managed mutual funds. Each of these funds have five years or more of returns data. 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.
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Here is a calculator to determine the t-stat. Don't trust an alpha or average return without one.
The Figure below shows the formula to calculate the number of years needed for a t-stat of 2. We first determine the excess return over a benchmark (the alpha) then determine the regularity of the excess returns by calculating the standard deviation of those returns. Based on these two numbers, we can then calculate how many years we need (sample size) to support the manager's claim of skill.
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 Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.