Vanguard is the largest fund management company in the world. Mostly known for being a pioneer in the development of index funds, they also carry quite a few actively managed funds in their lineup. Although their founder and well-known investment authority, Jack Bogle, often speaks against the use of actively managed funds for the vast majority of investors, Vanguard consequently promotes the same idea that Mr. Bogle attempts to refute. In fact, approximately 26% ($798 Billion) of all assets managed at Vanguard were actively managed as of December 31, 2015.1
This dichotomy between their passive roots and their active investment lineup begs a very important question? Do you believe that a passive investment approach is the best way to go? Is the active lineup just another revenue stream or does management actually believe they can produce significant alpha, or in other words, above average risk-adjusted results with consistency?
Many investors often ask us why we do not utilize Vanguard funds in our index portfolios, for which we have 2 main reasons. The first reason is purely performance based. Dimensional Fund Advisors has consistently been able to outperform a Vanguard fund of similar market exposure. You can find more information about this analysis here.
The second reason piggybacks off of the first. Dimensional is committed to their investment strategy. Their philosophy is clearly stated on their website, which says, “a scientific priority runs deep through Dimensional. We have a high regard for research, process, and time-tested data. A time line of innovation offers proof that Dimensional has always looked forward, ready for change, eager to go where the evidence leads.” You can find a more in depth statement on why we prefer strategies from Dimensional here. It is the scientific process and empirical inquiry that guides their vision. The empirical process has not led to the advancement of active investment strategies. In fact, it is quite the opposite. Most academics agree that investors should stay away from actively managed funds.
Nonetheless, we thought it would be interesting to examine Vanguard’s actively managed lineup to see if the success they have created with their index fund lineup has carried over to their active counterparts. We have done similar analyses for companies such as Wells Fargo, MFS Investment Management, JP Morgan, Lord Abbott, USAA, Midas Funds, Thrivent, American Funds, Fidelity Part 1, Fidelity Part 2, Oppenheimer Funds, T. Rowe Price and Invesco.
Our analysis begins with an examination of the costs associated with the 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, front end (A), level (B) and deferred (C) loads, and 12b-1 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 costs associated with implementing a particular investment strategy and can vary depending on the frequency and size of the trades taken by portfolio managers. We can estimate the amount of cost 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 1 year. This is considered an active approach and investors holding these funds in taxable accounts will likely incur a higher exposure to tax liabilities to short term and long term capital gains distributions relative to incurred by passively managed funds.
The table below details the hard costs as well as the turnover ratio for all 60 active Vanguard funds that have at least 3 years of performance history. 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 an equity strategy from Vanguard experienced a 0.36% expense ratio. Similarly, an investor who utilized a bond strategy from Columbia experienced a 0.21% expense ratio. These fees are substantially lower than the industry average, which increases the chance of potentially outperforming their respective benchmarks. The average turnover ratios for equity and bond strategies from Vanguard were 40% and 90%, respectively. This implies an average holding period of about 1 to 2.5 years, on average.This also implies that Vanguard’s active management team, on average, makes investment decisions based on short-term outlooks, which means they trade quite often. Again, this is a cost that is not itemized to the investor, but is definitely reflected in the overall fund performance. In 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.
The next question we address is whether investors can expect superior performance in exchange for the higher costs associated with Vanguard’s active strategies. We compared each of the 60 strategies since inception and 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 strategy at the bottom of this article. Here is what we found.
- 50% (30 funds) have underperformed their respective benchmarks since inception, having delivered a NEGATIVE alpha
- 50% (30 funds) have outperformed their respective benchmarks since inception, having delivered a POSTIVE alpha
- 3.3% (2 funds) have outperformed their respective benchmarks consistently enough since inception to provide 95% confidence that such outperformance will persist as opposed to being based on random outcomes
In general, we conclude that Vanguard’s family of active funds has no expectation of producing above-average returns for their investors. In fact, the chances are no better than a fair coin. The inclusion of statistical significance is key to this exercise as it indicates which outcome is the most likely vs. random-chance outcomes. Now, let's take a look at the funds that produced a statistically significant alpha at a 95% confidence level.
The 2 funds that had a positive alpha at the 95% confidence level were:
- Global Equity Fund (VHGEX)
- Health Care (VGHCX)
Before we get into the specifics of why we conclude that such outperformance is due to luck, as opposed to repeatable skill, we remind our readers that when examining a sample size of 60 individual funds, by chance alone we would expect 1-2 (1 in 40) to produce a statistically significant alpha. Therefore, it is hard to decipher whether Vanguard has actually demonstrated some skill or if this is merely an example of chance outcomes from a large sample size. To give a similar analogy, if we filled Yankee Stadium (54,251 max capacity) and gave everyone a coin to flip, just by random chance a handful of individuals might get 10 heads in a row. Are they skilled coin flippers? Of course not!
Further, it is quite common for inappropriate benchmarking among foreign and international investment strategies. Morningstar is limited in terms of successfully aligning the best commercial benchmark with each fund in existence, so there will be some error in matching up proper characteristics such as average market capitalization or average price-to-earnings ratio. For example, the benchmark for the Vanguard Global Equity Fund is the MSCI All Country World Index. In comparison to its benchmark, the Global Equity Fund is smaller in terms of market capitalization. Without controlling for this potential discrepancy, we may be attributing “alpha” to what is actually the “size premium” around the world. Remember, over the last 88 years, smaller companies have outperformed larger companies.
A better way of controlling for these potential discrepancies is to run multiple regressions where we account for the known dimensions of expected return in the US (market, size, relative price, etc.). For example, if we were to look at all of the US based active strategies from Vanguard who have been around for at least the last 10 years, we could run multiple regressions to quantify their alpha. The chart below displays the average alpha and standard deviation of that alpha for the last 10 years ending 12/31/2015.
As you can see, not a single fund produced an alpha that was statistically significant at the 95% confidence level (green shaded area). This is what we would expect in a well functioning capital market.
Unfortunately, this type of statistical analysis is also limited. Our model is only as good as the data that we use as the independent variables in the regression. For example, if we were to run a regression for the Vanguard Global Equity Fund, we would need a market, size, and relative-price factors for stocks around the world. No such database currently exists. The alternative would be to try to explain its performance using stock market information from the US (more robust data set), which doesn’t make a whole lot of sense since it is two completely different samples.
What can we conclude? In general, Vanguard has not demonstrated that their process of hiring the best analysts and managers and implementing their investment strategies is superior to anyone else. To say they apply a unique process to just 2 of their investment strategies seems very unlikely. The majority of active funds offered by Vanguard have failed to outperform their benchmark since inception. Of those that did by a statistically significant amount, it is similar to what we would expect by random chance alone. Among international and foreign-based investment strategies, bad benchmarking is rampant since there are not customized indexes for every type of investment strategy that exists. The existence of alpha may be the false attribution to a known factor as we concluded for the Global Equity Fund. In a global context, we see a very similar trend across many major fund management complexes, leading general intuition to prevail that Vanguard falls victim to their similar fate, which is the result of market efficiency, cost, and competition.
Based on our analysis, we challenge Vanguard to defend the reasons why they continue to offer actively managed mutual funds.
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.
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.
We have taken a deeper look at the performance of several other mutual fund companies and have come to one universal conclusion: they have failed to deliver on the value proposition they profess, which is to reliably outperform a risk comparable benchmark. You can review by clicking any of the links below:
1. Based on Morningstar Database. We define actively managed funds as the 60 individual funds we examined in this analysis.
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About the Authors
Tom Allen
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc. Â
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.