Inside the Vanguard Science Project

In my report on the latest Morningstar Investor Returns data, I noted an interesting performance detail: Investors in Vanguard's lower-cost Admiral share class were doing better than those in the firm's Investor shares by a margin that was greater than the gap in expense ratios. What's intriguing is that, in addition to new investors who open an account with $100,000 or more, Vanguard permits its most patient shareholders to invest in Admiral shares, too.

The initial requirements in July 2000 were: have at least $150,000 in a three-year old account, $50,000 or more in a 10-year-old account, or $250,000 or more in a new account. (Later, they lowered that final threshold to $100,000.) Thus, they set up a fascinating experiment to see if patient investors do better than their less-patient brethren.

Investor Returns Primer
Before I go further, I'll explain investor returns. You are familiar with total returns, which fund companies, Morningstar, and everyone else show for a fund's performance. These reflect how an investor who bought at the beginning of the time period in question and then held all the way through to the end would have fared. Dividends are assumed to be reinvested.

Investor returns adjust those total-return figures based on flows in and out of the fund, making it possible to see what the typical investor actually earned. We know that some investors are patient and that others move in and out quickly. Investor returns capture that. When you look at the gap between the two figures, you're essentially looking at the how well-timed the typical investor's trades were.

Passing on Savings
Vanguard created Admiral shares in attempt to deliver lower costs to the clients who cost less to serve in terms of percent per dollar invested. Those clients fall into two groups: big investors and patient, long-term investors. The latter group costs less because their limited trading lowers transaction costs, and they require less service whether online or over the phone. I suppose they even require less printing costs because Vanguard doesn't have to send them as many prospectuses when they buy a fund for the first time.

Vanguard is the only shop I know that did this for long-term investors. The minimum for Admiral shares was lowered last year, but I'm going to look at 10-year figures where higher minimums were in effect for nearly all the time.

Performance Comparison
Going back 10 years--not long after the Admiral share class was created--we can compare the investor returns for Admiral versus Investor shares. It turns out the more patient and/or wealthier Vanguard investors fared better than those in the Retail investor class most of the time. Specifically, in 13 out of 15 cases, Admiral share-class investors enjoyed better investor returns than those in the Investor share class. Their margin was greater than the difference in expense ratios.

For example, in the firm's flagship Total Stock Market fund, Admiral shareholders enjoyed returns of 6.16% annualized compared with 5.35% for Investor shares. At Vanguard Value Index, Admiral shareholders earned a 4.84% annualized return compared with 2.61% for Investor shares.

There were a couple exceptions. Admiral shareholders in Vanguard Intermediate Term Tax-Exempt gained 2.45% annualized, while investor shareholders earned 2.68% annualized.

Still the trend seems clear. Investors who were inclined to invest for the long term were likely to have better returns. A look at how the markets have worked during the past 10 years illustrates why that is. We had two bear markets and two dramatic rallies. Those who sold equities in the bear market missed out on the rally and therefore nearly all would have been better off riding out the bear market.

Will the Outperformance Persist?
Rallies and sell-offs alike are sneaky things that usually hit before we expect them. And I should note that while the Admiral shares provide a wonderful lab for watching patient investors, this isn't a perfect test. The Admiral shares were created at the start of the bear market and it's possible that the effect of money going in near market lows exaggerated the benefits enjoyed by patient investors. We'll have to keep watching to see if this trend holds up.

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