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Active and index funds: No contradiction

December 11, 2013

At Vanguard, we're often asked these questions:

  • If you believe so strongly in index-funds, why do you offer actively managed mutual funds?
  • Aren't index funds and active funds mutually exclusive, like oil and water?

Although index funds and active funds have different goals, there's actually no contradiction in valuing both approaches. In fact, they can work well together.

True, Vanguard is closely associated with indexing. We introduced the first index mutual fund for individual investors in 1976, and today we manage hundreds of billions of dollars in index mutual funds and index-based exchange-traded funds (ETFs). But we also have deep roots in active management, stretching back to the founding of Vanguard Wellington Fund in 1929.

We believe both active and index funds can play a role in a balanced and diversified portfolio. They're not oil and water, but more like peanut butter and jelly. Or—to use a Philadelphia analogy—like mustard on a soft pretzel.

Costs and the core-satellite approach

Of course, being Vanguard, we also believe it's important to focus on the costs of your investments, regardless of whether they're indexed or actively managed. Cost is a headwind for all investing; the more you spend, the less you get to keep. So the prudent way to invest, we believe, is in a low-cost fashion, whether indexed or active—or both.

Your index funds can provide a low-cost approximation of a particular market segment's return, as long as the funds successfully track their benchmarks. And your active funds can give you a chance to outperform the market, albeit with the risk of underperforming as well.

One approach for combining two types of funds is called "core-satellite." Index funds could be the core of your portfolio, and the satellites could be active, complementing the core holdings.

Why indexing

When first introduced, index funds were controversial because they challenged the widely held assumption that most active fund managers could consistently outperform market averages. Index funds sought to track the performance of a market benchmark, like the S&P 500 Index, rather than beat it.

It turns out that index funds had logic on their side. Investors as a group make up the market, so as a group, we earn—before expenses—whatever return the market provides. Some investors can outperform the market, but they have to be balanced out by other investors who underperform. A majority can't be above average, after all. When the costs of investing get factored in, Vanguard research* shows that the average investor will actually earn less than the market rate of return.

Over time, index funds have performed better than many of their actively managed counterparts.* The reason has to do largely with costs. Because index funds don't need to employ large numbers of analysts and managers to decide what to buy and sell, they can operate more efficiently. Keep in mind that costs are deducted from fund shareholders' assets, meaning investors in low-cost index funds get to keep more of their funds' returns.

*Source: The case for indexing, Vanguard Investment Strategy Group, February 2011.

Active funds' opportunity

Some advocates of index funds argue for what's known as the "efficient market hypothesis." This is just a fancy way of saying that stocks and bonds are reasonably priced because the markets efficiently distribute information to all investors. Therefore, according to this theory, picking individual stocks and bonds doesn't pay off because there aren't "bargains" for active managers to discover.

However, as with everything in life, the markets aren't perfect. They're reasonably efficient, perhaps, but there are mismatches. And while Vanguard believes there's a very persuasive argument for index investing, that argument doesn't rule out well-executed active management at a reasonable price. By keeping costs low, we believe we increase the chances that our active fund managers can outperform their benchmarks and their peer funds.

Notes

  • All investments are subject to risks, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss in a declining market.
  • Investments in bonds are subject to interest rate, credit, and inflation risk.
  • Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
  • Vanguard ETF Shares are not redeemable with an Applicant Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
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