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Live webcast replay: Are actively managed funds right for you?

May 31, 2013

Replay and transcript from a recent Vanguard webcast

Actively managed funds are an interesting topic for Vanguard, since we're known as an indexing pioneer. But actively managed stock funds may have a role in your portfolio too.

In this live webcast on May 9, 2013, Steve Holman of Vanguard Flagship Services® and Daniel Wallick of Vanguard Investment Strategy Group talk about the characteristics of successful actively managed funds, Vanguard's approach to active management, and how to decide if actively managed funds have a place in your portfolio.

Watch the full replay »

Other excerpts from this webcast:

Transcript:

Sean Hagerty: Good evening, everyone. Thanks for joining us for this live webcast. Whether you're viewing the webcast from a computer, tablet, or smartphone, we're happy to have you with us.

I'm Sean Hagerty, and today we're talking about actively managed stock funds. While Vanguard is known as an index leader, we also offer an array of actively managed funds. So after viewing this webcast, we'd like you to have a better understanding of a few things: 1) the characteristics that make active stock funds successful; 2) Vanguard's approach to active management; and 3) how to decide if actively managed funds have a place in your portfolio.

We have two experts joining us today: Daniel Wallick, a principal in our Investment Strategy Group, and Steve Holman, a principal in Vanguard Flagship Services®. Daniel, Steve, thanks for being here.

Daniel Wallick: Great to be here.

Steve Holman: Thanks, Sean.

Sean Hagerty: Good to have you here.

Before we get started, I wanted to mention that if you should experience any audio or visual issues during the webcast, please refresh your browser by pressing F5 on your computer.

Okay, so actively managed stock funds … It's an interesting topic for us because, well, as I said, we're Vanguard, an indexing leader. But as you'll find out today, active funds can also have a place in your portfolio.

We'll get started by chatting with Daniel and Steve but, as always, this webcast is about you and your questions, which are already pouring in as I can see on my computer screen already. We'll spend most of the broadcast answering those questions and we'll continue to take them during today's event.

You also can send questions to Twitter by simply using #VGLive, and I'll be looking at the Twitter feed on the iPad right next to me. Okay?

Daniel Wallick and Steve Holman: Sounds great. Great.

Sean Hagerty: Great. Before we get into our discussion, we'd like to ask our audience a question. On the right-hand side of the screen, you'll see our first poll question, which is: "What's the primary reason you've invested or would consider investing in actively managed funds?" The answers you can choose from are: "strong past performance," "diversification," "a desire to beat the market," or "access to talented fund managers." Please respond now and we'll share your answers in just a few minutes.

So, while we're waiting for our audience to respond, let's talk a little bit about why Vanguard, a company known for indexing, even offers actively managed funds. Daniel, why don't you start by giving some insights on why we're even here tonight to start?

Daniel Wallick: Sure. Thanks, Sean, I'd be happy to do that. And, indeed, Vanguard really has a reputation for talking about the value of indexing all the time. But interestingly enough, back in 1928, when the first Vanguard fund was started, it was an active fund, so the precursor to what Vanguard is today. And, in fact, if you look at our assets in aggregate, almost half the assets in the entire complex are actively managed, and within the equity space itself, we have over $300 billion of actively managed money.* That puts us well in the top three of all active managers. So we actually have a huge base of active management. And we thought it would be valuable to talk about what's that role in anybody's portfolio and how can that help anybody.

Sean Hagerty: That sounds great. Let's see how we're doing on our poll. Please answer if you haven't answered already. So while we're getting the poll results up, Steve, why don't you start by talking a little bit about why would a Vanguard client want to even think about active funds? What role does it have in a portfolio? And maybe even start with what is an active fund compared to an index fund, anyway? Let's go back to the basics.

Steve Holman: Yes, I think it's important to level set exactly the differences between index and active. And so, essentially, when we talk about index, and I think we'll use the terms "index and "passive" interchangeably, but it's essentially describing the same thing.

Sean Hagerty: So let me get that right—indexing and passive, same thing. Okay.

Steve Holman: The exact same thing.

Sean Hagerty: Great.

Steve Holman: And so, basically, an index fund is a fund that's designed to follow a market benchmark or an index that's out there. So, for example, the S&P 500 or other indexes that folks might be familiar with. There's no manager discretion involved, so it's, really, the intent is just to follow this benchmark.

The index that the passive fund is following could be broad or narrow; it could cover the entire market or just specific segments. And the index funds tend to be lower cost because there is no manager discretion.

Now, on the other hand, active fund is more around; I guess you can consider it stock picking. There's the asset manager or the fund manager's following a specific strategy to achieve gains that would exceed market averages. So the intent is to achieve outperformance. Again, an active fund could be broad, covering broad swaths of the market, or it could be very specific for a particular market segment.

Now the costs for active funds tend to be a little higher because essentially you are paying for the talent or the stock-picking ability of that fund manager.

Sean Hagerty: Because it actually takes some people to do the stock picking, analysts and whatnot. Dan, anything else to add on that?

Daniel Wallick: I would just say that when we talk about indexes, we typically talk about what's called a market-cap-weighted index, where you're getting a weighted average of all of the securities that are out there in whatever that space is. Again, trying to give people a weighted average. And, again, what active managers are trying to do is beat whatever that index is or beat whatever that benchmark is.

Sean Hagerty: Sure, right.

Steve Holman: And to your original question, someone would select an actively managed fund if they were seeking outperformance for some proportion of their portfolio.

Sean Hagerty: Okay, great. We have our poll results in, so let's take a look and see what folks have been saying. In an answer to the question "What's the primary reason you've invested or would consider investing in actively managed funds?" it was a kind of a split vote here: 14.5% said "strong past performance"; almost 30% said "diversification"; a quarter of the group said "a desire to beat the market"; and almost 31% said "access to talented fund managers." What do you think of those results, surprising?

Steve Holman: Yes, I find it surprising, particularly the high proportion of folks highlighting diversification. I think we'll probably spend some time talking about the diversifying benefits of an active fund, but I would have guessed that trying to beat the market would have rated highly, which it did. As well as—we know that when we're having discussions with clients that past performance is a pretty compelling factor.

Daniel Wallick: Although, if I were to add the last two numbers together, that's about 56%. So that's more than half the people are thinking about trying to beat the market, because part of that's talent. And you presume that the talent that they're trying to acquire is talent-beating. And that's generally why people do; it is because they want a higher return of some way.

Sean Hagerty: Than the benchmark can give them.

Daniel Wallick: Right.

Sean Hagerty: Okay, sure. Well, let's ask the audience another poll question then. And what we can do is we can ask you: "Which of the following"—and, again, this is on the right-hand side of your screen—"which of the following would most likely cause you to consider leaving an actively managed fund?" So we just talked about what makes you consider doing it. If you owned one, why would you leave it? And the choices are: "poor performance," "a fund manager change," or "an opportunity to move to a lower-cost fund."

So go ahead and do those answers. And I think while we're waiting for that, for you to answer those questions, we'll dive right into the questions from the audience. And I'll start with Rick from Apple Valley, Minnesota, who makes a statement really: "Many studies have shown that actively managed funds do not outperform passively managed funds often because actively managed funds have higher expenses." We talked about that already a little bit, Steve. "So I hope the seminar deals with the rationale for actively managed funds."

So, Daniel, maybe, what is the rationale for actively managed funds?

Daniel Wallick: I think Rick is right on. He has identified that, most often, active managers will underperform their benchmark. The latest numbers we have—over the long period of time, it's probably only a third of active managers who at any one time can outperform the benchmark. And there's no consistency, typically, in those active managers who do that. So that's one side of the equation.

Another side of the equation is 75% of the assets in the industry are still in active funds. So there's this sort of dilemma going on, this paradox in the industry—the numbers wouldn't speak to that, but a lot of people still invest in that. And so I think the answer is, why does Vanguard do it or why do we have this conversation around it? It's that, is there a way to do this effectively, ultimately? And that comes down to, is there a good risk tolerance? Are people comfortable with the attributes of active, ultimately?

Steve Holman: Yes, and I think it's interesting that he quoted the industry figures, but we know at Vanguard—not a high proportion of folks invest in active at Vanguard. It's roughly around 15%, but that's still a not insignificant proportion of folks that are trying to achieve these, the outperformance, the extra gains that sometimes come with active management.

Sean Hagerty: Yes, sure. Daniel, I want to follow up with one other thing. You talked about the fact that it might not be persistent as well. So what have our studies shown about active fund managers and how often they beat the market and whether it's persistent or not?

Daniel Wallick: Sure. So we did a recent study where we look at funds that won over a 15-year period. And, of those, more than half would underperform for seven of those 15 years. So if you think about that, that's almost half the time a long-term winner is actually underperforming the market. So the way I try to visualize that is it's a roller coaster ride. And to the extent that you're comfortable with the ups and the downs of the market, there is the possibility that a manager will succeed over the long term. But there can be long stretches where managers are underperforming; and unless you're comfortable with that dynamic, then active management may not be the right place for you.

Sean Hagerty: All right. Let me go to another question from Ward in South Lake, Texas. And, by the way, Ward is consistent with a lot of other folks who ask questions like this. Ward says, "I'm a disciple of index investing." Many, I think, Vanguard investors are, in fact, disciples of index investing, and that's one of the reasons they're here. "So if I consider managed funds, what percent of my portfolio should I invest in managed funds? Should it be across asset classes, and to what extent does it help my diversification?" So, Steve, why don't you try and nail that one?

Steve Holman: Sure. There's a few questions in there, and I think the short answer is that you don't necessarily have to have active funds in your portfolio and, ultimately, it's an individual decision. But the way I think we think about it is that you start with your overall asset allocation. You want to think about the proportion that you want to have in your portfolio divided between fixed income and equity. And then once you get to that equity proportion, then you can choose to slice it up however you like, and you could consider your active allocation as a component of your overall equity allocation.

And so then it becomes a function of how much risk do you want to take? How much active risk? Certainly there's the desire to achieve gains that outperform the market, but then there's also the risk of underperformance. So you would need to weigh how much you're willing to factor that risk relative to just investing in an equity index fund. So, really, it's an individual decision, and it's hard to put an exact number on it, but it's really up to the individual.

Daniel Wallick: Sean, if I may, to sort of follow up what Steve said. There have been studies done about wins and losses. And, from a behavioral standpoint, most of us as investors have a 2½ times more aversion to a loss than we do have to a gain of the equivalent amount. So when we talk about this risk tolerance that Steve or I talk about, it's, really, you need to be comfortable with the fact that you could be underperforming for a while and that could be significant. And you have to be comfortable that you can stick with your plan through that.

Steve Holman: And I think the second part of your question was around diversification.

Sean Hagerty: Diversification, yes. Does active management and adding that to your portfolio actually help with diversification?

Steve Holman: Yes, and I think the answer is: "Yes if you do it in a thoughtful way." And I think sometimes people get enamored with returns or they want a fund that has historically provided high returns and it may not provide the diversification that they assume because, given the specific strategy or the philosophy of the fund manager, it may cause overlap with other investments that they have in their portfolio.

So, I think, if you kind of start with the top-down approach, start with the overall asset allocation, choose the allocation that you want to put towards active, and have it make sense so it fits in with your overall goals, then it can provide a diversification benefit.

Sean Hagerty: But, really, is the purpose of investing in actively managed funds for diversification? Daniel, what do you think?

Daniel Wallick: No. Really, it's for long-term outperformance. Again, if you can handle the characteristics of that, and we'll have a discussion through this hour about what those characteristics are. Again, if you're comfortable with those characteristics, there's the possibility, not the guarantee, but the possibility that an active fund can outperform. And that would be really the primary reason to invest in active funds.

Sean Hagerty: Okay, sounds good. I'm going to remind the audience that if you have any issues with your browser, you can just hit F5 on your keyboard and that should clear it and reset your browser. So, if you're having any issues, hit F5 and that should clear the issues. Thanks.

Okay, let's go to the poll results from the second poll. And what we're seeing here is a little bit of a bigger shift in one direction as opposed to the last question, where we had an even split. So, "Which of the following would most likely cause you to consider leaving an actively managed fund?" "Poor performance," 78%; and "a fund manager change," less than 10%, only 8.5%; and "an opportunity to move to a lower cost fund," 13.5%. So, Steve, what do you think of those results?

Steve Holman: Well, maybe not so surprising, and I think poor performance could or could not be a good reason. I love Daniel's analogy of the roller coaster. And I think if you invest in actively managed funds—one of the Certified Financial Planners shared this anecdote that you can't ask to get off the roller coaster midway through. You have to ride the ups and downs until the end to get the full benefit of investing in an actively managed fund. And I think a lot of times what people do is, when there's one of those steep declines, they're like, "Stop the coaster!" So I think, you know, thinking about having active management as part of your overall strategy and then making the decision based on that overall strategy when it is a good time to leave. And then it could be because of poor performance.

Sean Hagerty: Daniel, what did you think?

Daniel Wallick: Well, when I'm on a roller coaster, I just shut my eyes. I can't take those long dips. But this is interesting because this is aligned with conventional wisdom, which is that you should drop out of an active fund after a track record of poor performance. And, in fact, institutions do this as well as individuals. And what we're going to talk about through time is that the analysis we've done actually shows that there are other reasons that should trigger you to get in or out of a fund. And it's not recent performance. And that feels very counterintuitive to most investors, and certainly most institutional investors and individual investors. But it's actually their other factors—their qualitative factors we think are really actually more important.

Sean Hagerty: So how important is the word "patience" to somebody who wants to invest in an actively managed fund?

Daniel Wallick: I think it's key. So there are a couple of characteristics that you'd have to sort of be comfortable with to invest in an active fund. And let me just back up for one minute. When you hire an active manager, there should not be the expectation that they're going to have an outperformance every day or every week or every month or even every year, and there are possibilities of even a decade where they can underperform. So patience is really key for being able to use an active manager. We try to do that when we hire managers, and we would suggest that investors do the same thing because of that variability of return.

Sean Hagerty: And, I guess, Steve, patience would also be a thing to think about with broad asset allocation regardless of whether you're in actively managed funds or index funds.

Steve Holman: Yes. At Vanguard we believe in discipline. And you have to be particularly disciplined when you're investing in active funds. One way to think about it is that when the fund is performing poorly, if you're in the active fund, there may be a seed of doubt in your mind. It could be just because of the market as a whole or it could be because the manager is making bad decisions. And sometimes that seed of doubt leads you to make rash decisions and pull out of the fund when a little more discipline, a little more patience would have paid off.

Sean Hagerty: Sure. Okay. Let's dive into the questions a little bit more, and Nile from Boise, Idaho. Hello, Nile. Hope you're watching. I'll throw this to you, Daniel: "Do the Vanguard actively managed funds have a better track record than the non-Vanguard actively managed funds? And, if so, how much better?"

Daniel Wallick: Right. So let's take the question first, and then I think I actually have a slide that can answer that question.

Sean Hagerty: Sure.

Daniel Wallick: But we have to be careful about time periods here, because any analysis or any judgment is going to be made over a specific time period. So if you take one time period versus another, you're likely to get a different result. So if we actually pull up the slide, we have a calculation, I think, that looks at how the median Vanguard active fund has done over the 5-, 10-, and 15-year period, along with other active funds, along with the industry index funds.

And if we look at that, we can see that over some period of times, many period of times, Vanguard actually outperformed both other active funds and the broad industry index structure. Not all periods of time, but on many of them. And that's a surprise to some people. But the real key is that Vanguard active funds are surprisingly low-cost relative to both industry index funds and to other active funds.

Sean Hagerty: Yes, I think this bears some discussion. So, when we're looking at the way that Vanguard funds are performing, the non-Vanguard funds are performing, what are some of the things that somebody should look at with respect to active performance? I think we also showed it against index funds and we showed it against non-Vanguard active funds. What are some of the things that somebody should be looking at when they're trying to break down the differences between—? What are some of the factors that could account for the differences between those funds and the respective benchmarks? And start with the index funds—what's the difference there?—and then industry funds and then Vanguard funds.

Daniel Wallick: So let's talk about a couple of things. There's a big decision you have to make: Do you want to be in an active fund or an index fund? And, presumably, most index funds are going to be tightly driven around the benchmark. So the variation in their performance, regardless of who you're picking, is going to be fairly small.

When you pick an active fund—and there on that chart we just showed median, so that's just sort of the weighted average, right?—there's a broad distribution around that. And so there's this selection variable in active funds that really comes out that you have to consider. So, again, there's a more of a random selection function when you have active relative to an index fund.

Sean Hagerty: Yes. I think some of the ways we talk about that with an index fund is relatively predictable compared to an active fund, which would be less predictable in terms of its outcomes.

Daniel Wallick: Right, it actually gets back to that roller coaster ride again. So that index fund may have ups and downs, but they should be smaller than an active fund.

Sean Hagerty: And the index fund would have ups and downs the same way the market itself would have ups and downs.

Daniel Wallick: Broad market would, yes.

Sean Hagerty: And the active fund would have ups and downs like the market, but also relative to the market, it might have some ups and downs depending on how that fund is performing.

Daniel Wallick: Correct. And so there's always that relative comparison. So how has my active fund done relative to the market? And when you underperform you feel terrible, and when you've outperformed you feel pretty good.

Steve Holman: And I think it's fair to say that the way that the active funds achieve the higher returns is that they sometimes take on additional risk. Essentially there's no free lunch, and so the variability on the active funds has to be something that the client is comfortable with.

Sean Hagerty: Sure, okay. We have a question from Jessica from Boston, who's listening in tonight. And she asks: "You emphasized the word 'patience'; therefore, are you suggesting actively managed funds might be a smart choice for someone younger or far away from retirement?" Steve, you want to start with that one?

Steve Holman: Yes, certainly. I think patience is required no matter how old you are. And, certainly, when you have a longer time horizon, a longer investing horizon, the patience and that discipline can pay off. But I think in the end, and I think Daniel made the point very well, that even the best-performing active funds have periods of underperformance. And you have to have the fortitude and the discipline to ride out those periods so you can achieve those long-term gains, those long-term outperformance.

And again, I think that's certainly true for younger investors who may have concerns about, are they going to have enough to retire, what's their portfolio going to look like years down the line? And it may be at times tougher to stomach some of those ups and downs, especially when they tend to have more risk in their portfolio or higher proportion of equities because they have a longer investing horizon.

Sean Hagerty: Which, of course, is the first decision they have to make about—

Steve Holman: Yes, overall asset allocation.

Sean Hagerty: Overall asset allocation and then make the decision about active or passive.

Daniel Wallick: Right, but to Steve's point, if you have a big asset allocation, there is the possibility you could have some index and some active in that portfolio together, depending on how much variability from the market you care to have.

Sean Hagerty: Yes, it's fair to say a large percentage of investors, based on what we know about the industry, probably has some mix of index and active in their portfolio.

Daniel Wallick: Yes.

Sean Hagerty: We have another question that just came in—David from Connecticut—and, Daniel, I'll throw this your way: "What characteristics does Vanguard look for when selecting active managers?"

Daniel Wallick: Great. We really look at qualitative factors. And we actually may have a slide that speaks to this, where it talks about four sort of soft factors and two sort of outcome or harder factors. And those factors are philosophy and process and how does the organization go about their business. That's not performance, right? The performance is an output from that. But, really, who are the people, how long have they been doing it, do they have a replicable process? Really, all these sort of due diligence functions to do that. And then out of that come some functions, which include performance and what that portfolio is.

Now, overlaying all of this, which is what's not on the chart but also very crucial, is can you acquire these attributes at a reasonable cost? And it's really this combination of talent, as we would identify with those items on the chart, plus reasonable cost or reasonable fees, really puts you in a place where you have a higher probability of success.

Steve Holman: And applying the client perspective, a lot of times folks will say, "Hey, I want fund A in my portfolio," because they read about it in a magazine or they looked at the returns, and they say, "I want that number. I want those returns in my portfolio." And sometimes they don't really see how it fits into their overall strategy. And by doing that, it could radically change their overall asset allocation.

And so, sometimes we really say, "Hey, do you understand the investment strategy? Do you understand what the fund asset manager is trying to accomplish? And then, once you have that understanding, does it fit into your strategy?"

I think another thing that we try to do is have folks identify what we believe are enduring investment strategies, as opposed to fads or sort of the latest thing that's the hot thing in the market. So a lot of times—if you look at the short-term performance rankings and so forth, a lot of times it's very specific actively managed funds in a particular sector or a particular area that's performing very well. And I think it's our belief that a lot of times that's not an enduring strategy, that's not something that you could build a long-term success on.

Daniel Wallick: Right. If I may, the example of that is the managers that we hire. So we hire outside managers, subadvisors, to manage our active equity funds. We have about 30 of those. The average tenure of those managers for Vanguard is 13 years. And if we exclude the recently hired managers, so just the ones we've hired recently, that number is about 17 years. So we are very patient with our managers because we've done this due diligence upfront on these qualitative factors that give us some confidence that they are going to be successful over the long term.

Steve Holman: And, thus, we're less likely to offer a fund that is kind of reflecting the latest fad.

Sean Hagerty: Sure. But, you know, Daniel, because we hear it so often, qualitative factors? Aren't you looking at all the numbers and the data and you're looking at performance and performance is driving what you want to do in terms of hiring? You want to hire the manager with the best performance.

Daniel Wallick: Correct. And most of us fall to the proof statement of that, and the proof statement is obviously performance. The challenge is over what period of time is it reasonable to judge somebody.

Sean Hagerty: Sure.

Daniel Wallick: And an example I would use would be, say you have a particular style manager, like a value manager. I know that's a broad grouping of certain types of stocks. Well, you can have 15 different styles of value, and market conditions can be positive or negative in any one of those managers. So the style can be just impacted by factors beyond the manager's control, and it's not necessarily a reason to leave that manager.

Sean Hagerty: Sure. Okay. How often do we make manager changes? Amanda from Athens, Georgia, asks: "How often do we make changes? How do you find out if a manager has changed? And should you be concerned if the manager does change?"

So talk about, when does Vanguard actually make a change? How does that work?

Daniel Wallick: Right. So there's a process for reviewing the managers on an ongoing basis, and that's always brought to the board of directors to make any change on any of the funds. I don't know what the exact number is, but I imagine it's once every three years or five years we might make a change.

Now we may add managers or we may take somebody out to pull somebody there. But any manager notice we make, the shareholders will be notified of that change. Now that can either be replacing a manager completely or, say, we have multiple managers in a single fund, we may be adding another one.

Sean Hagerty: And, again, if we're changing managers, is it because of performance usually or because the other factors that you've talked about with respect to the firm and the people and the process and the philosophy?

Daniel Wallick: Right. So the whole process we have is qualitatively driven. It's those soft factors—the people, the philosophy—are they the same? Can they replicate it? If those fundamentals change, then we get concerned as a firm, and we would look to consider changing somebody. If there's a radical change in those. In other words, if there's a key person and they leave, that might be a reason to do it. If, however, everybody's intact and they're doing the same process, and they just happen to have a period of bad performance, we actually think it's very important that we stick with that firm for the long-term success.

Steve Holman: And even though we change managers relatively infrequently, I think, make sure that folks know that there is a great deal of diligence that goes around the manager evaluation and selection and all of that. But I also think there's responsibility on the client's part to understand what's happening if they have active management in their portfolio, so when these changes take place, understanding the nature of the change, and then does that fund still fit within their strategy.

Sean Hagerty: Sure. Judith from Ketchikan, Alaska, who's got to be in the afternoon there, asks, and I'll ask you, Steve: "What do you mean by benchmarks? You talked about benchmarks." Why don't you just talk about what do we mean by benchmarks?

Steve Holman: Yes, I think the most common example is the Dow Jones or the S&P 500. But, basically, they are indexes that reflect a certain proportion of the market. So the S&P 500 is what we consider a broad index, and then there's multiple examples of indexes or benchmarks that cover particular portions of the market. So, really, ultimately, the goal of an index fund is to match that benchmark. Again, not stock-picking, not selecting specific securities, but to replicate as closely as possible the returns from that benchmark.

Sean Hagerty: All right, great. Thanks so much. Now, Glenda from Texas—and, Daniel, I'll throw this your way: "Explain why there are multimanagers in a fund." And I think it's, just for point of clarification for those who don't know, Vanguard offers many actively managed equity funds. Some have a single manager and some have multiple managers in one fund. So talk about why would we have a multimanager fund.

Daniel Wallick: And again, often conventional wisdom is that the way for active management to be successful is it sort of takes a cowboy, right? It takes a single person who can pick very concentrated stocks and be quite different from a benchmark to be successful. And under that framework, a single-manager fund might be more successful than a multimanager fund where, again, intuition would assume that those multimanagers may actually be crossing each other and cancelling each other out.

The data shows, however, that that's actually not true. That fund structure, whether they be a single manager or several managers, really is not a determinant of success. It's more so the performance is relatively indistinguishable between those two.

That gives us confidence that we can have one manager or multiple managers in a fund and the success will be the same, or potentially be the same, be consistent along those lines. So the reason we would have more than one manager is, if you think about, say, small cap, an individual manager may have a limited amount of money that they are comfortable investing at any one time. And so there's a possibility of putting multiple managers together to provide that to clients, in addition to which alpha is additive, right? So outperformance of multiple managers can actually lead to more performance.

Sean Hagerty: And alpha is a technical term for . . . ?

Daniel Wallick: For outperformance, success.

Sean Hagerty: Outperforming the index, excess returns.

Daniel Wallick: Exactly.

Sean Hagerty: Okay. And do you think there's any advantages to that structure of multimanager? How could you structure it as something that might actually give you an advantage?

Daniel Wallick: So, again, from a pure math standpoint, there's no absolute better answer. You can't prove one or the other, and you wouldn't want to do that. But to some degree, on a historical basis, multimanager funds tend to be slightly less diffuse in terms of return. So their returns tend to be slightly tighter, so more consistent, than actively managed funds. And that might be a reason to do it too.

Sean Hagerty: And that might be because those fund managers are complementary within a particular style of investing.

Daniel Wallick: Right.

Sean Hagerty: Terrific. The next question is John from Albuquerque, and I'll ask both of you this question: "How does Vanguard manage to keep fees low for actively managed funds?"

Daniel Wallick: I think we may actually—I don't know if we have a slide for that or not, but let me talk about this in a couple different ways. So, number one, what we do is, we can provide a significant amount of assets to an individual manager. And those assets, with a small fee, can lead to a reasonable check for the manager; and managers are smart enough to do the net present value of that small fee times a large amount of money, and that's a reasonable check.

We can also—again, as I mentioned earlier, we tend to hire managers for a long period of time; and so that long-term relationship is very, very beneficial to a manager. In fact, they'd rather be with us for a long period of time at a modest fee than with a firm at a higher fee that's more likely to fire them.

So both of those structures allow us, in the long run, to be able to manage fees and actually provide them in a reasonable context. And if I just may put some context around that, so our fees—the median fee for Vanguard active funds is 37 basis points.

Sean Hagerty: Describe basis points.

Daniel Wallick: Okay, so that's 0.01% of a fund, right?

Sean Hagerty: Sure.

Daniel Wallick: So let me just put that in context for everybody. That is, our active funds are almost a third the fee of the industry average; and they are cheaper than half of the indexes that are out there provided by the rest of the industry. So our active funds are actually very inexpensive relative to the industry.

Steve Holman: And then I think another element of that, to the original question, is, part of the reason that we can have lower fees is our structure. So, certainly, at other companies, when you have the expense ratios or the fees that you're paying, part of that is going to provide returns to the owners. But given that the owners—the fund owners—are the owners of Vanguard, we return those profits, that excess money, back to the clients in the form of lower fees, lower expenses. So I think that's a very important element combined with the factors that Daniel mentioned.

Daniel Wallick: There's also one other thing, which is sort of the icing on the cake. We do performance fees for our active managers. So, if they do well, they get a bonus; and if they do poorly, we claw some fees back. And that aligns their interests with the clients' interests.

And what's interesting about that is, it seems sort of a sensical thing to do, a reasonable thing to do, but only about 4% of the assets in the entire industry have that structure on them. So not all managers have that, and we just find that healthy.

Sean Hagerty: Clarify one thing for me. So the expense ratios we were just talking about, 0.37, I think, was Vanguard active equity funds? Is that right?

Daniel Wallick: Yes.

Sean Hagerty: And then the 1.05 was industry equity . . .?

Daniel Wallick: Industry equity.

Sean Hagerty:. . . Or active equity funds?

Daniel Wallick: Yes.

Sean Hagerty: Terrific. That sounds great. Let me move on to another question from Robert from Madison, New Jersey: "The classic problems with managed funds is that it is difficult or impossible to predict when a successful fund will underperform. How do you decide when to move out of a fund?" Steve, you want to start and maybe, Daniel, fill in?

Steve Holman: Yes, I think we've talked about a few of these things, and I think I would caveat all of this by saying that a lot of times the decision to move out of an actively managed fund is driven by tax implications.

So a lot of times we see folks that would, ideally, like to switch funds, but if they're holding it in a taxable account, there could be capital gains that have built up. And if they don't necessarily want to pay a big tax bill, then they may be locked in. So that's why we certainly advise that if you have an actively managed fund, it's certainly to your advantage to hold it in a tax-deferred account, such as an IRA or a 401(k).

I think one reason is that the fund no longer is helping you achieve your investment objectives. So as people age, they may want less risk in their portfolio; they may be uncomfortable with the volatility of a fund. And so, to reconcile, to get to an overall allocation that fits your needs, you may choose to pare back your allocation to equity.

I think another option, in going back to the poll question, I wish more people would have mentioned moving out of a fund to a lower-cost option. That certainly is a legitimate reason, and we see that a lot. When clients bring assets to Vanguard, a lot of times they bring other funds from other companies' active funds, and we have a comparable fund at Vanguard that is a much better deal. And so we would encourage them, again, factor in tax considerations to make that switch.

I mean, the best way to think about it is, if there's two cars from two car makers and they're, for the most part, comparable or almost the same, and one is twice the price, then it would make sense to purchase the cheaper car. And so that's the guidance that we provide to our clients.

Sean Hagerty: Daniel, any comments there?

Daniel Wallick: I was going to say, so I think what Steve has very well articulated is how, as an investor, what you should consider in terms of where your asset location is and your portfolio.

The other factor is, just from a pure fund-by-fund analysis, we sort of talked about it slightly earlier, which was, again, we would use qualitative factors and not short-term performance. Again, it feels very counterintuitive, but not looking at performance—three-year trailing, five-year trailing—as the measure of is somebody being successful or not, but the qualitative factors. Has the fund manager changed? Has their style changed? Have they changed their philosophy or any of that process? Again, those are the soft factors, but those would really be the reasons on why to change. If you made the commitment initially and you're going through a period of rough patch, we would say you should really think about sticking with it.

Steve Holman: And then one thing I would add is, the decision on what to do with the money is as important as deciding to get out of the fund. And, sometimes, what we see is, people are chasing performance. So the performance is poor in one active fund, they see the numbers on another fund, and they want to move to that; and that fund may be very different than the active fund that they had before. And so I think, again, being thoughtful on how whatever fund you purchase fits into your overall strategy is very important.

Daniel Wallick: If I may, so we've been talking around it; these behavioral issues are really, really crucial. We all have this penchant for wanting to do well. We think about that often on a relative basis. You know, psychiatrists have actually looked at happiness, and it's often a relative comparison, right? If I have a better suit or if I'm taller or if I have a bigger TV, I feel better. It's all relative comparison. We don't want to bring that to this fund selection process, because we'll always be chasing performance in that regard.

Sean Hagerty: Sure. And I guess the risk is, if you bought the fund because of performance in the first place, it's likely you might sell it because of performance when you are dissatisfied. And so, really, it starts with buying it for the right reasons, which is some of those qualitative things. We think that the conditions exist that this fund would be a fund that would do well over a long period of time; and, if those conditions don't change, don't change the fund.

Daniel Wallick: Along with your personal assessment that you are comfortable with the variability in that performance, and you're willing to stick with it for a long time, for sure.

Sean Hagerty: Sure, okay. Let's move on to another question, and it's similar, but I do want to talk a little bit about this. Robert wants to know: "When using actively managed funds, do you suggest a buy-and-hold strategy, a buy-and-sell various funds, or rebalancing a collection of funds as values move up and down?" So it's a little bit of a twist on the same question, but talk about Robert's question there.

Steve Holman: Yes, I think, going back to what we talked about before, as your active allocation as part of your overall equity allocation, you would manage that portion like anything else. And so at Vanguard we do believe that you'll get the best benefit if you do buy and hold for an extended period of time, and you should periodically rebalance to a target allocation.

So, for instance, if you have an active fund and, say, it's 5% of your portfolio, the fund does well and, all of a sudden, it's 10%, that would be an opportunity for you to pare down your exposure to that back down to 5%. So that's the classic selling high.

And on the other hand, if the fund does poorly and the allocation falls down, then that's a chance to buy low; and I think that's what we would encourage. And that's true for not just active, that's true for any of your investments; but the key is to stick to a target allocation, and active would be a part of that.

Sean Hagerty: Okay, terrific. One question we've heard from a number of different folks, but Sean from Los Altos, California, asked a question that was common: "In what segments of the market is there a better chance for active funds to beat the indices?" It's a common, I think, question we get. Can you beat the market in small cap or in international easier than large cap? So, Dan, do you want to talk about that a little bit?

Daniel Wallick: So I'm going to give a response; and, Sean, you tell me if it gets too technical, and Steve can clarify.

Sean Hagerty: I'll do that. I'll be the technical police.

Daniel Wallick: What a lot of people talk about is, are there inefficient markets or less efficient markets where we have a higher probability of performance? And, again, Sean, as you mentioned, a lot of people think of small cap or emerging markets as places to do that.

And what I think happens in those places is that people confuse two concepts: dispersion, which is the pattern of returns—how wide the pattern of returns for all the managers will be relative to the benchmark—versus the probability of any one of those funds outperforming. And what we find, in certain sections of the market you have these wide dispersions. So you have a wide array of where the funds all might end up, but the probability of picking any one of those to be successful is no greater.

We don't see that any one part of the market versus another is more or less efficient. The probability of success is relatively the same. What is different is those individual experiences will either be much wider or tighter to the benchmark.

Sean Hagerty: Yes, that's a little surprising because I think a lot of common wisdom says that, in fact, there's less efficiencies in some parts of the market that aren't covered as much by Wall Street, so to speak. But you think that's probably not the case.

Daniel Wallick: Yes, the research we've done, that's not the case. What happens is that the numbers get—people get messed up with the numbers, and they sort of draw a wrong conclusion; but our broad experience is that's not the case. Again, difference between dispersion. So dispersion is, if you pick a manager and he wins, he's more likely—he's likely to win by a bigger amount. But you have just as much probability, in that sense, of picking a loser who's going to lose by a larger amount. So that distance issue is there as opposed to your ability to be any smarter picking a manager.

Steve Holman: Yes. And one of Vanguard's investing principles is picking an asset allocation that's aligned with your investment goals and needs; and I think the foundation of that is a study that I believe we did last year. I think it confirmed a previous study that 88% of the variability of your—88% of the performance patterns in your portfolio is due to the simple asset allocation, the proportion of fixed income to equity. Only 12% is the stock selection within those categories.

So we advise people, as opposed to trying to pick the sector or pick the—you'd be very well off just choosing asset allocation—

Sean Hagerty: Broad asset allocation.

Steve Holman: Sticking with it, be disciplined for the long term, and you're way ahead of the game.

Sean Hagerty: Okay, great. Rene from Las Vegas has a question. "I'm very new to this," says Rene. "I just transferred some funds into Vanguard a couple of months ago. My question is, how often should I be checking the funds? Daily?"

Steve Holman: Daily, probably not, because I think that there's the distraction factor. You kind of see the ups and downs; and there's a lot of noise in the market; and I think, sometimes, whether it's the ups and downs in the market, or the commentary that you hear on cable TV, may lead you to feel like you need to take action when you really don't.

So that's why we say, pick—monitor your investments at what you feel comfortable, but be very thoughtful and careful to tune out the noise. Invest for the long term. Don't make rash decisions. Don't do something that would skew this asset allocation that you've set up for yourself.

Daniel Wallick: So, one way to do that is to think—if you're a long-term investor, is to think of how often you want to rebalance your portfolio. And once a year, for most people, is a reasonable amount. So, in theory, you could look at your portfolio—well, maybe twice a year, once to rebalance and once for tax purposes, if you have to pay any taxes. But you could look at your portfolio just once a year for rebalancing purposes.

Sean Hagerty: And be—

Daniel Wallick: And be perfectly fine.

Sean Hagerty: That'd be enough.

Daniel Wallick: Yes.

Sean Hagerty: Okay. Jeffrey from Wadsworth, Ohio, says: "Many say that actively managed stock funds do better in down markets. Is this assertion correct?" Any truth to actively managed managers can avoid down markets?

Daniel Wallick: Again, it's intuitive that that feels right. As an active manager, they're thinking about it. You'd have that feeling that a manager could sort of sense when things are going bad and pull back out, but the numbers actually show that that's not the case. There's sort of a random selection. There's no real absolute pattern other than a majority will underperform under any long-term conditions.

Steve Holman: Yes, and I think the other factor—and I'm surprised we haven't talked about cost as much as I thought we would but, certainly, in down markets the additional fees and expenses associated with active are really a drag on returns.

Sean Hagerty: Okay, sure. I'm going to throw this one to you, Steve. Doug from Springfield wants to know: "How do I choose among all the many and various Vanguard funds that you have to choose from?"

Steve Holman: Well I think the short answer is: "Give us a call and we can have representatives talk you through." And, again, I think we wouldn't start necessarily on this fund versus this fund; we would have a broader discussion about what you're trying to accomplish, what are your investment goals, what's your risk tolerance, and get an understanding there and then decide what makes sense. And if you feel strongly that you want to have active, then we certainly can provide guidance and assistance to help you decide.

Daniel Wallick: If I may make one other observation, from an advice standpoint, we typically suggest that, within an asset class, investors be market-cap-weighted. So if you're interested in—

Sean Hagerty: What do you mean by market-cap-weighted? I'm in a technical place again.

Daniel Wallick: Thank you for checking me.

Sean Hagerty: Do it again.

Daniel Wallick: All right, what that means is, you want to be proportional to the market. So we would suggest that you—if the market holds 70% large cap and 10% mid cap and 10% small cap, or whatever those numbers might be, even though that only equals 90%, that you hold the market in that same proportion because there's no predictability in when one section of the market's going to do better than another, really.

So start with a market-cap weighting. And then you can make that up with one fund, with one fund that just covers the whole market, or a series of funds; but, when you do the series of funds, you want to make sure that the aggregate ends up in the same place.

Steve Holman: And if I can put a plug in for vanguard.com, we make it very easy for you to evaluate your portfolio against the market-cap weighting. There's many portfolio tools and analytics that you can go in and see the proportion, how your allocation in your portfolio compares to the market weightings.

Sean Hagerty: Sure. Would another way to think about market-cap weighting be that if the total value of Apple stock was 2.2% of all of the stocks in the United states—

Daniel Wallick: Which it is.

Sean Hagerty: Then the fund that you own might have 2.2% of its fund invested in Apple stock?

Daniel Wallick: Right.

Sean Hagerty: And that's what we mean by market-proportional.

Steve Holman: Right. But you could decide that you may want to be overexposed to one area; but I think the key is, do that on purpose. Don't do it inadvertently.

Daniel Wallick: Right, we would say market-cap weight is a great starting point for everybody; and then, if you want to be consciously overweight, make that decision consciously. But don't do it because you're chasing, I don't know, the blue fund or the red fund or whatever that might be.

Sean Hagerty: Sure. I want to bring back one of the charts to look at the returns where we originally talked about Vanguard active funds, non-Vanguard active funds, and all industry funds. And, Daniel, somebody asked a question. Jerry from Erie, PA, says: "What accounts for the difference in the performance between Vanguard funds and non-Vanguard funds? How much of that is cost?" If we talk a lot about cost, how much of that is cost, how much of it is the manager selection process that we talked about?

Daniel Wallick: Well, both are really important. So we've done some studies on cost, and low cost is the only thing that we can identify ahead of time to help us target a potentially successful manager. It's the only quantitative tool we have in our arsenal to sort of identify potentially useful managers. But that alone can't get us there, right? So the other thing that's very useful is, you have to be able to identify talent. So it's some combination of both of those.

That said, cost is the most certain thing you know when you purchase a security, right? It's the only known when you actually purchase a security. You know how much it costs. Everything else is a to-be-determined function in the future. So, that's why low cost is really, really a crucial function to whatever investment you have, but particularly when we're talking about active management. That's why low-cost active is really the function that needs to be incorporated by investors.

Sean Hagerty: Sure, okay. I think the key point is, if you look at the chart and you had 0.51 excess returns for the Vanguard funds over that 15-year period, a long time period, but -0.33 for the non-Vanguard active funds, cost would be a pretty significant portion of that; but cost, alone, can't guarantee success. You have to have cost, and you have to have good manager selection.

Steve Holman: I believe we have another chart that shows the direct relationship between the cost of an active fund relative to the long-term performance. I think we could pull that out.

Daniel Wallick: The line chart.

Steve Holman: Yes. And then, again, I think what the chart, when it comes up, clearly illustrates that—basically, the way to look at this is, across the bottom is the rating of the cost of an actively managed fund. So on the left-hand side, those are the most expensive funds, and on the right-hand side, those are the least expensive. And then the vertical axis is the percentage of the funds that outperform over, and you see the various periods of time. And you can see that very direct link between the cheapest funds having a higher proportion of outperformance. It's pretty stark, actually.

Daniel Wallick: Right. And what you see there is that the—there's lots of lines on that chart, but these are all different time periods and different periods. But it's true for every time period we look at, which is that the lowest-cost funds always do better than the higher-cost funds. Now, what's also interesting about that chart is, if you look at the percentage on the left-hand side, none of them are beating the 50% mark. So that cost alone won't get you a winner. That's where you need this talent, to be able to identify talent comes in also.

Sean Hagerty: Cost, talent, and patience.

Daniel Wallick: Yes.

Sean Hagerty: All three ingredients needed to be successful in active fund management.

Daniel Wallick: Absolutely.

Sean Hagerty: Well, I wish we could go on forever, and I think the questions, as I'm seeing them come in, we could go on forever. But I think we've run out of time. So, Daniel, Steve, thanks so much for sharing your insights with us tonight. That's really been terrific. Before we sign off, any final thoughts, Daniel?

Daniel Wallick: I do. I think we've talked about a lot of stuff, and I actually have one last slide I'd like to pull up which is, you know, what does this mean for you? So we've talked about all the great things that Vanguard does with active funds and active funds in general, but what does that mean for any investor? And here's what I'd say.

I'd say that indexing is a great place to start; it's a good default for everybody. But to the extent that you're comfortable with the characteristics of active, which means that potential roller coaster ride, and so there could be long periods where you underperform, and that you have the patience to stick with it, active can actually have a role in your portfolio. So to the extent that you can acquire talented active at low cost, and, again, low cost is a crucial factor here for active, then potentially there's a role for active in your portfolio.

Steve Holman: And what I would add is, for those reasons, if you make the decision to invest in active, there's a lot of advantages of doing it at Vanguard.

Sean Hagerty: Right. Terrific. Thanks both.

Daniel Wallick: Thanks, Sean.

Steve Holman: Thank you.

Sean Hagerty: And from all of us here at Vanguard, we'd like to thank you for joining us this evening. In a few weeks, we'll send you an e-mail with a link. That link will allow you to replay today's webcast—I'm sure you might want to watch it three or four times—along with a transcript for your convenience.

And if we could have just a few seconds of your time, please respond to a quick survey that will appear on the right-hand side of your screen. We appreciate your feedback and we welcome any suggestions you have about topics you'd like us to cover. We do take them seriously, and we'll absolutely take them into consideration when we're thinking about future webinars.

Thank you so much for being with us and thank you for allowing us to earn your trust every single day. Enjoy the rest of your evening. Good night.

Disclosures

All investing is subject to risk, including the possible loss of the money you invest.

For more information about Vanguard funds, visit vanguard.com, or call 877-662-7447, to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Asset figures are as of June 30, 2012.

Bonds and bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.

Diversification does not ensure a profit or protect against a loss.

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.

© 2013 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.

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