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Say What?

Vanguard's take on how to select actively managed funds.

John Rekenthaler, 09/30/2013

Prudent Counsel
The headline for a recent Vanguard podcast, "Some success factors for actively managed funds," caught me by surprise. The world's largest index-fund provider isn't the first company that comes to mind for giving advice on active management.

On second thought, though, the assignment made sense. Aside from its indexed assets, Vanguard is one of the industry's largest managers of active funds. True, most are semi-passive bond funds that don't stray far from their benchmarks, but the company's domestic-stock funds, international-stock funds, and sector funds are afforded more freedom. Also, as pioneers of the subadvisory approach, whereby a fund company hires outside investment firms to run portfolios rather than use in-house personnel, Vanguard is in particularly good position to discuss manager selection.

The company's arguments are straightforward:

Keep costs low. As Jack Bogle has stated, the correct distinction is not between index funds and active funds, but instead between low-cost funds and high-cost funds. The general rule that cheap funds beat expensive funds--a rule that applies to all longer time periods for all investment categories--holds true regardless of whether a fund is indexed. The average Vanguard actively managed fund is actually cheaper than most other companies' index funds. It should come as no surprise, then, that Vanguard's actively run funds have outperformed most index funds over time.

Have flexible sell rules. Of Vanguard's most successful actively managed funds over the past 15 years, two thirds suffered at least one stretch of three consecutive years of underperformance during that period. Investors following the simple sell rule of "three strikes and you're out" would have erred. Almost all of those funds also had a five-year period wherein they lagged either an index or more than half their category peers. Again, an inflexible rule of dropping underperformers would have proved unhelpful.

Having flexible sell rules means patience. The average active-fund manager that Vanguard has hired has been on the job for 13 years. That's a much lower turnover rate than is found among mutual fund investors, who tend to run through their funds every three to four years (a precise figure is difficult to get). Those figures are not directly comparable, as an investor may need to sell a fund for reasons that do not apply to Vanguard's situation, for example to raise assets or move to a different asset allocation. They do, however, suggest that the Vanguard organization is somewhat more patient than is the typical fund investor.

(As a side note to the issue of having sell rules based on underperformance, Morningstar's Don Phillips tells how a representative for a major index-fund provider--not Vanguard--once showed him the S&P 500's calendar-year returns. The representative then counted back year by year, eliminating an active fund if it trailed the S&P 500 in any one of those calendar years. By Year 8, he was done; no active-fund manager had beaten the index for all eight of those years. This demonstrated the futility of active management, stated the representative.

(If it hasn't struck you by now, it soon will: That same argument could be used to prove the futility of indexing. Just take that active manager's calendar-year returns, count back year by year, eliminate any index if it lags the fund in a given year, and before too long there won't be any indexes left.)

is vice president of research for Morningstar.

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