When John Bogle served as chief executive of Vanguard Group, critics often accused him of taking a hypocritical stance on actively managed funds. For years, Bogle promoted index funds and said that most actively managed funds are doomed to fail. Despite this view, Vanguard always offered actively managed funds along with passive choices. Bogle himself invested his personal money in actively managed funds, including Vanguard Windsor (VWNDX), which was run by his friend, John Neff.
Since Bogle retired as chief executive in 1996, Vanguard has continued singing the praises of index funds and staying largely mute about the virtues of actively managed funds. But recently the company's attitude appears to have shifted. In an article that appears on the company's website, Vanguard argues the case for active funds. “We believe that both active and index funds can play a role in a balanced and diversified portfolio,” the article says. “They're not oil and water but more like peanut butter and jelly.”
Efficient or Not?
Vanguard takes aim at the efficient market theory, which says that stocks are always reasonably priced. Citing the theory, many proponents of index funds have said that there is little point in trying to pick stocks actively because it is hard to find bargain-priced stocks. The Vanguard article quotes Gus Sauter, the company's chief investment officer, who quarrels with the theory. “I don't think that markets are completely efficient,” he says. “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.”
While Vanguard has made a clear departure from Bogle's traditional position, the embrace of active funds is still lukewarm. The article makes the case for a core-satellite approach. The idea is to build a core of index funds and complement that with a satellite of actively managed funds. In the end, index funds should play the dominant role in portfolios.
But Vanguard investors who follow the company's advice may be sacrificing returns. By many measures, Vanguard's actively managed funds are clearly superior to the company's index offerings. Of Vanguard's 21 active equity funds with 10-year tracks records, 15 have outperformed their benchmarks. Top performers include Vanguard Global Equity (VHGEX), Vanguard Prime Cap (VPMCX), and Vanguard Windsor II (VWNFX).
In many cases, the active funds are clearly superior compared to the equivalent Vanguard index funds. Consider Vanguard Capital Opportunity (VHCOX), a large growth fund. During the 10 years ending in April, the fund returned 6.2 percent annually, outpacing Vanguard Growth Index (VIGRX) by 3 percentage points. Vanguard International Growth (VWIGX) returned 6.7 percent, compared to 5.3 percent for Vanguard Developed Markets Index (VDMIX).
The superiority of the active funds is no accident. The chief advantage of index funds is their low expense ratios. But at Vanguard, the active funds are almost as cheap as the passive portfolios. While Vanguard Capital Opportunity has an expense ratio of 0.48 percent, Vanguard Growth Index charges 0.28 percent. The active managers have been able to overcome their small expense handicaps. Many of the top funds are run by outside subadvisers. Having hired subadvisers for decades, Vanguard has become skilled at picking the best. When the managers fail to deliver strong results, Vanguard fires them and tries again.
Should Vanguard investors avoid index funds altogether? Not necessarily. But before buying any fund, you should compare it to all the alternatives, including active and passive portfolios. Besides considering fees, look at volatility and past performance in up and down markets.
The Active Winners
By many such measures the actively managed Vanguard Equity Income (VEIPX), a large value fund, is superior to its passive equivalent, Vanguard Value Index (VIVAX). The active fund returned 4.8 percent annually over 10 years, compared to a return of 3 percent for the index portfolio. While it achieved higher returns, the active fund also took less risk, as measured by standard deviation. The active fund has a standard deviation of 20.43, while the index fund came in at 22.77. During the downturn of 2008, the active fund lost 31 percent, while the passive portfolio dropped 36 percent.
The portfolio managers of Vanguard Equity Income achieved their winning record by seeking undervalued stocks that deliver above-average dividends. To avoid trouble, the managers stick with solid blue chips that have slipped out of favor temporarily. Holdings include familiar names such as Johnson & Johnson and Home Depot.
Another compelling active choice is Vanguard Dividend Growth (VDIGX), a large blend portfolio. During the past 10 years, the fund returned 2.9 percent, compared to a return of 2.7 percent for Vanguard 500 Index (VFINX). The active fund had a standard deviation of 17.72, compared to 21.88 for the passive fund. The active fund did particularly well in downturns. The fund lost 25.6 percent in 2008, while the index fund dropped 37 percent.
Vanguard Dividend Growth looks for solid companies that have enough cash flow to support increasing dividends. Holdings include PepsiCo and International Business Machines.
For investors seeking a small growth fund at Vanguard, the choice between active and passive is less clear. Vanguard Small Cap Growth Index (VISGX) returned 9.5 percent, outpacing actively managed Vanguard Explorer (VEXPX), which returned 6.4 percent. But the passive fund posts a standard deviation of 28.64, compared to a figure of 25.8 for the active fund. The managers of the active fund prefer solid companies with moderate prices, and the stocks in Vanguard Explorer tend to be slightly bigger and cheaper than the holdings in the index fund. As a result, cautious clients may prefer the active fund, while investors with more aggressive tastes have a good reason to prefer the index fund.
Enthusiastic proponents of indexing object to the idea of comparing index and active funds. Index funds provide reliable results, while active funds are unpredictable, the indexers argue. But index funds can deliver bad surprises, and each of the hundreds of passive choices comes with different qualities. Some index funds excel in bull markets while others thrive in hard times. To build sound portfolios, it is important to look at funds objectively. By shopping for the best fund — whether active or passive — you can increase the odds of building successful portfolios.
