Markets & Economy
Some success factors for actively managed funds
September 12, 2013
Diane Streleckis: Hello, and welcome to Vanguard's Investment Commentary Podcast Series. I'm Diane Streleckis. In this month's episode, which we're taping on August 22, 2013, we're talking about the allure actively managed funds have for investors and some things to keep in mind about them. I'm here with Daniel Wallick, a principal in Vanguard's Investment Strategy Group. Hello, Daniel. Thanks for joining us.
Daniel Wallick: Hi, Diane. It's a real pleasure to be here.
Diane Streleckis: Many investors are drawn to actively managed funds because of the opportunity they have to get higher returns than those of their benchmark indexes. You've done a lot of research in the active management approach. Based on that research, what are some things that investors can keep in mind when they're considering investing in these types of funds?
Daniel Wallick: So we've done a lot of research on this topic for several years and published many papers. What we found is there are really three key factors that can lead to success with active management. Those three key factors are low cost, being able to identify top talent, and having patience with the managers. To some degree, that seems counterintuitive, right? How do you get top talent at low cost? How do you buy a Rolls-Royce for an inexpensive price?
First, low cost is the only thing we know ahead of time that can improve the odds of investors in outperformance. We've looked at a variety of different factors. We've run analysis and, really, the only thing we know ahead of time that can improve odds is low cost.
However, low cost alone won't guarantee outperformance, and that's why you also need to be able to acquire talent. So some combination of low cost and talent is what's going to get you there. But given the relative inconsistency of any outperformance—and this is true for all managers—you also have to have patience to live with those decisions.
Let me just give you one set of numbers around the patience decision. We looked at all the active funds over the last 15 years, and we found that 18 percent of them outperformed (Source: Vanguard research paper The bumpy road to outperformance). Practically all of them had at least five years where they underperformed through that 15-year period. So practically all of them underperformed for a third of the time. Now, these all ended up being long-term winners. Of those that outperformed, two-thirds of them also had three consecutive years of underperformance. Using the three-year track record as a reason to get rid of somebody: That actually would have kicked out two-thirds of the winners along the way.
There's a real inconsistency in the returns, which is why patience is important, along with low cost, along with top talent.
Diane Streleckis: Can you explain a little bit more about the differences between how Vanguard approaches active management and how some other fund families do?
Daniel Wallick: Sure. We think there are actually five key factors that make Vanguard distinctive.
Number one is our ownership structure. We are a mutually owned company.* We are not owned by a third party or by public equity holders, so we don't have to return capital to a third-party group. That allows us to run at-cost.
Number two is: We use performance bonuses. If a manager does well, they'll get an extra bonus. But if they do poorly, they actually have to give back some of their fees. That may sound rather intuitive—that's what managers should do, but only 4 percent of the assets under management in the mutual fund space use that structure (Source: The case for Vanguard active management: Solving the low-cost/top-talent paradox?).
It aligns the interest of the manager with the interest of the investor. If the manager does well, then the investor will do well and the manager gets paid for that. If the manager does poorly, then the investor gets some money back from that.
The third thing we do is: We typically are dealing in big size. Our mandates to outside managers will typically be in the billions. We can go to a manager and say, “Listen, we're going to give you a mandate of a billion dollars, but we're going to give you a modest fee with that.” The paycheck they get is still a reasonable fee. The manager's smart enough to figure that out.
The fourth one is: We have a lot of patience with our managers. If you look at the average tenure for the active managers that we hire, and these are outside firms, the average tenure is 13 years. Now, if we take out the managers we've hired in the last five years, that number grows to 17 years. That's an awfully long time.
Then the last factor, again along the patience line, is that our manager search process is ultimately led by our CEO. We've had three CEOs in 40 years. That's not a lot of turnover. They bring a long-term horizon to this decision-making process. That allows us to be very patient with the managers we hire.
The other thing is the ability to identify managers' talent. We think the critical factor there is using qualitative factors, not quantitative factors, to try and identify that. “You know it when you see it” as opposed to “I can give you a checklist to identify what talent is.” We'll spend years getting to know managers before we hire them to make sure we're comfortable with these qualitative factors.
Diane Streleckis: You've talked about how Vanguard approaches active management versus other fund families, but how do we know if it actually works?
Daniel Wallick: We try to look at that in a couple of ways. One, if you look at Vanguard active, the median fee paid for Vanguard active is cheaper than 50 percent of the indexes that are out there in the industry. That number surprises many people. There are a couple of reasons for that. One is, some people just charge high fees for indexes. The other is that there are many different types of indexes, and some of them are market cap, which are cheaper, and some of them are other things, which might be more expensive.
We've looked at how well Vanguard active has performed over time. There's a paper on this topic (The case for Vanguard active management: Solving the low-cost/top-talent paradox?), and what we found was, on a market-cap-weighted basis, if you just counted all the Vanguard active funds, on an average annualized basis, there's been, historically, 24 basis points of outperformance by Vanguard funds in total. That's relative to a costless benchmark. Now, I should qualify that by saying that's a 25-, 30-year period. We have calculations of a decade where there was underperformance.
Diane Streleckis: What points do you recommend advisors consider about active fund management when building portfolios and talking about the approach with their clients?
Daniel Wallick: Active can work, but it's not necessarily consistent, and that's the key factor I think advisors need to come to grips with.
If you can acquire active at a low cost and you can get talent, then fine—it's potentially reasonable. But you as the investor, or you as the advisor, have to be patient with that decision. That's really the only way it works—is being able to live with the roller coaster and not necessarily pull back if there's a bad year or bad two years or even a bad three years.
If that's not something you can live with and stick to your guns, then maybe active's not the right thing. But to the extent that you are comfortable with that structure, then active can have a reasonable role in your portfolio if you can acquire it at low cost and you have some talent associated with that.
Diane Streleckis: It sounds like, if you've got a longer time horizon, that might be better.
Daniel Wallick: Right. If you're in the accumulation phase, if you don't necessarily need to spend in a reasonable amount of time, then, yeah, then maybe active. If you're more looking for an income basis and you're concerned about what the volatility in your assets is going to be, then maybe active might be less of an appealing option for you.
Diane Streleckis: Daniel, thanks for joining us today. We really appreciate your insights and your time.
Daniel Wallick: Diane, it's a real pleasure to be here with you.
Diane Streleckis: And thank you for joining us for this Vanguard Investment Commentary podcast. Be sure to check back with us each month for more insights into the markets and investing. Thanks for listening.
*Vanguard is client-owned. Shareholders own the funds that own Vanguard. Vanguard provides its services to the Vanguard funds and ETFs at cost.
- All investing is subject to risk, including the possible loss of principal.
- Past performance is no guarantee of future results.
© 2013 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.
An episode from Vanguard's Investment Commentary podcast series
Actively managed funds may appeal to investors looking for an opportunity to earn higher returns than those of a benchmark index. Daniel Wallick, a principal with Vanguard Investment Strategy Group, shares some points to keep in mind when considering this type of investment, including research on the factors that can help lead to success with active management.
- All investments are subject to risk, including the possible loss of the money you may invest.
- Past performance is not a guarantee of future results.