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Getting Active in Indexland

How do Vanguard's actively managed funds stack up against its index funds?

Dan Culloton, 11/01/2010

Have an opinion? Head to the end of the article and leave a comment!

Vanguard built its name with index funds, but its heritage is with active management.

The family's oldest funds, including Vanguard Wellington VWELX and Vanguard Windsor VWNDX, are actively managed, and much of its current lineup consists of actively managed offerings. Vanguard's assets, as of Sept. 30, 2010, are split almost down the middle, with a little more than $537 billion, or more than 45% of total mutual fund assets, in actively managed funds, and about $639 billion, or more than 54% in index funds, according to Morningstar data. Despite its status as the destination for many investors on the latter side of the active/passive investing debate, Vanguard takes both sides.

Some diehard indexers find it hypocritical. How can the firm that has done more than any other to popularize the notion that most active managers can't beat their indexes over time offer managed funds alongside passive ones? Aren't those active funds doomed to fail? The answer is no, according to a comparison of Vanguard's managed funds and index funds.

Broadly Speaking
To see how Vanguard's active funds have stacked up against its index mutual funds, I  compared the returns of the managed mutual funds with the index funds in their respective categories. I wanted to see how you fared in recent years if you picked a Vanguard active fund over a rival index fund in the family. I looked at data through midyear 2010 but focused on long-term periods.

Odds are good that you fared well. Grouping the funds by broad asset classes--domestic stocks, international equity, and taxable bonds (Vanguard has no municipal-bond index funds)--and asset-weighting their returns show that Vanguard's actively managed funds have been competitive with their indexed counterparts. In the domestic-stock group, passive funds beat the actives in the year-to-date and trailing-year periods through the end of June 2010; but the managed funds had the edge in the longer three-, five-, and 10-year spans. Among international-equity funds, the actives won the year-to-date, one-, and 10-year time periods, while index funds prevailed in the intermediate term. Indexing, however, had the edge among taxable-bond funds, prevailing in all trailing periods save the year ended in June.

Winners
To see how consistent the active funds have been, I looked at rolling returns. Vanguard has 25 actively managed funds that have been vying for dollars with sibling index funds for at least five years. (I used investor class shares and didn't count the family's tax-managed funds, which are quasi-index funds, or its funds of funds.) Fifteen of them have beaten the oldest index fund in their category in more than half of the rolling five-year periods in which they have contended.

There are 19 actively managed funds that have competed with passive alternatives in their peer groups for at least 10 years; 12 of them have bested the index fund in more than half of the rolling 10-year periods. Seven of the actively managed funds beat the index fund in all the periods.

Vanguard Capital Opportunity VHCOX, currently a large-growth fund, was the best. It never trailed Vanguard Growth Index VIGRX in any five- or 10-year rolling period between September 1999 and June 2010. Vanguard Wellington, Vanguard PRIMECAP VPMCX, and Vanguard Windsor II VWNFX also never trailed in a 10-year rolling period and beat the rival index fund in more than three fourths of the rolling five-year periods. Vanguard Strategic Equity VSEQX and Vanguard Equity-Income VEIPX won in every rolling 10-year period and in more than half of the five-year periods. Vanguard US Value VUVLX was undefeated in rolling 10-year periods but struggled over rolling five-year periods.

 

Losers
Vanguard US Growth VWUSX was the most futile fund. It beat Growth Index once in 152 five-year rolling periods from December 1992 to June 2010 and in none of the 92 rolling decades in that span. US Growth trailed Growth Index by an average of 500 basis points, or hundredths of a percent, in those rolling 10-year periods--not pretty. Vanguard recently replaced one of the fund's subadvisors, AllianceBernstein, with teams from Delaware Investments and Wellington Management.  PAGEBREAK

Other funds lagged their rival index funds over more than three fourths of their rolling five- and 10-year periods but put up a better fight than US Growth. Vanguard Growth Equity VGEQX trailed Growth Index by an average of 175 basis points over its 10-year periods. Vanguard Explorer VEXPX, Vanguard International Growth VWIGX, Vanguard Short-Term Investment-Grade VFSTX, and Vanguard Long-Term Investment-Grade VWESX looked merely mediocre, lagging their index alternatives by fewer than 60 basis points on average in the rolling 10-year periods going back to the middle to late 1990s.

A few funds upsides didn't make up for their downsides versus their competing index funds. When Growth Equity lost to Growth Index in 89 of 92 rolling 10-year periods, its deficit was much wider, on average, than its margin of victory in the three rolling periods in which it prevailed. Vanguard Capital Value VCVLX beat the Vanguard 500 Index VFINX in nearly two thirds of 43 rolling five-year periods, winning by an average of nearly 200 basis points in successful periods. When it trailed the index, though, it did so by more than 300 basis points. This helps explain why Vanguard in recent years has moved to tone down these funds by changing managers and adding subadvisors.

Alpha Dogs
Finally, to see whether Vanguard's active funds did better or worse than expected, given the level of risk they were taking, I looked at their alphas relative to the oldest index funds in their peer groups. Over the trailing five years ended in June, 13 of the 25 active funds with index rivals had positive alphas, meaning they performed better than expected relative to the passive fund, given the active funds' risk levels. In the trailing 10-year period ended in June, 11 of 19 funds with index alternatives had positive alphas relative to the passive options.

Once again, Capital Opportunity, PRIMECAP, and Wellington did far better than expected, given their risk profiles, while US Growth and Growth Equity did far worse than expected. Explorer, which has good results versus its category and until recently was an Analyst Pick, posted negative alphas versus Vanguard Small-Cap Growth Index VISGX. That indicates its seven subadvisors really haven't added much value over time. The benchmark-hugging quant fund, Vanguard Growth & Income VQNPX, also did worse than expected over all time periods.

Conclusions
Vanguard and even its founder, Jack Bogle, have never said it's impossible for an active fund to beat its benchmark over time. Rather, they have contended it's difficult to know in advance which active funds will outperform. Even if you think you can find winners, they say, it's best to favor funds that share some of indexing's most salient traits, such as low costs, diversification, and lower-than-average turnover. That describes most of Vanguard's active funds and helps explain their success versus their passive siblings.

It pays to be selective with Vanguard's active options, though. Funds subadvised by PRIMECAP and Wellington have been consistent winners. Though some big funds with multiple subadvisors, such as Windsor II, have been able to stay in the hunt, others, namely Explorer, are nearly index funds themselves. And there are recently overhauled funds, such as US Growth, that still have poor long-term records. Overall, there's reason to believe in many of the active funds offered in the Vatican of indexing.

Dan Culloton is an associate director of fund analysis for Morningstar.

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