John Bogle

Vanguard Makes the Case for Indexing

John Bogle

     As someone who follows the world of passive investing quite closely, one publication that I eagerly await every year is The Case for Index-Fund Investing1 from Vanguard Research. As with the Standard and Poor’s Index versus Active (SPIVA) Scorecard2, the conclusions reached are:

     1) The average actively managed fund has underperformed its benchmark, and the extent of underperformance increases directly with the length of the evaluated time period. There are no “inefficient” market segments where active funds have an advantage.

     2) The performance gap worsens once “survivorship bias” is taken into account (i.e., once the performance of terminated funds is included).

     3) Persistence of performance among past winners is no more predictable than a flip of a coin.

The ascendancy of indexing is a story unto itself. Citing Morningstar data, the authors state that assets in U.S.-domiciled index mutual funds and exchange-traded funds (ETFs) accounted for 34% of equity and 18% of fixed income funds as of year-end 2012.

     In a separate study3, Vanguard evaluated the impact of survivorship bias on performance results. The authors found that surviving funds generally outperformed funds that were liquidated or merged. In the 18 months prior to merger or liquidation, the non-surviving funds lagged their benchmark by an average of 3.58%. It is important to remember when looking at the returns of actively managed funds as a group that the returns of the dead funds are normally not included, which significantly increases the average return of the surviving active funds. Over the 15-year period studied, 46% of the funds did not survive. An additional pitfall in the evaluation of active fund returns is the selection of the benchmark. The authors found that quite often, the prospectus benchmark does not reflect the asset allocation of the fund. For example, the S&P 500 Index is often chosen as the prospectus benchmark, even though the fund has a significant exposure to international stocks.

     Besides the prospect of lower returns resulting from the high expenses of active management, investors should also be concerned with potentially higher volatility (risk). Vanguard found that in every time period they evaluated in excess of one year, the median active equity fund showed higher volatility than the overall market. In the case of active management, higher risk does not lead to higher returns, so why do investors keep falling for it? The answer, of course, is the hope of picking a winning fund. The problem, however, is that even if a would-be manager picker had been so fortunate as to pick a fund in the top quintile of the five years ending 12/31/2007, the probability that it would have remained in the top quintile of the subsequent five year period was only 15%, which is less than the 20% that we would expect from chance alone. Again, this is exactly what Standard and Poor’s reported in their Persistence Scorecard.

     An additional myth that is busted by both Vanguard and Standard and Poor’s is the notion that actively managed funds tend to outperform in bear markets because active managers can move into cash or rotate into defensive securities to mitigate the downturn.  As the authors of the Vanguard study observe, “In reality, the probability that these managers will move fund assets to defensive stocks or cash at just the right time is very low.” In four of seven bear markets since January 1973, the average active fund did not outperform the index.

     Since reasonable investors do not limit themselves to a single asset class but rather hold portfolios of multiple asset classes, the question of active vs. passive becomes even more important. The probability of a portfolio of actively managed funds outperforming a corresponding portfolio of lower-cost index funds over a long time period is close to nil, and this does not even account for the higher probability of poor investor behavior with actively managed funds such as chasing returns. An additional important advantage of indexing is the maintenance of control over the asset allocation. As shown in the SPIVA study, the problem of style drift is rampant with actively managed funds. Over the five year period ending 12/31/2012, less than 50% of domestic equity funds survived the period and remained style consistent.

     Of course, as far as we at Index Funds Advisors are concerned, Vanguard is just preaching to the choir. For us, the case for indexing was made when Jack Bogle founded Vanguard and the first retail index fund in 1975. Curiously, although Vanguard makes a very strong case for indexing, it still has about a quarter of its mutual fund assets actively managed. In fairness, some of these funds were inherited from other managers such as the Vanguard Wellington Fund which is one of the five oldest mutual funds in existence, and many of them possess the desired characteristics of index funds – low cost, low turnover, broad diversification, style consistency, and minimal cash drag.

1Philips, Christopher B., and Francis M. Kinniry Jr., 2013. The Case for Index-Fund Investing. Valley Forge, PA: The Vanguard Group.

2http://us.spindices.com/resource-center/thought-leadership/spiva/

3Schlanger, Todd, and Christopher B. Philips, 2013. The Mutual Fund Graveyard: An analysis of Dead Funds. Valley Forge, PA: The Vanguard Group.