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Rekenthaler Report

Say What?

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

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.)

Demand skin in the game. Vanguard's performance bonuses cut both ways. If outside managers beat their benchmarks, they receive more money than in the standard contract. If, however, they trail the benchmarks, then they forego some of the payment.

This isn't a tactic that fund investors can emulate, as very few mutual funds aside from Vanguard's offer symmetric performance fees. Most of the industry's performance fees are built so that if the coin lands heads, the fund company wins, and if it lands tails, it doesn't lose. That is, the fund receives a higher payout from shareholders (via the management fee) if it has a good year, and it doesn't give up anything in a bad year. Such performance fees are worse than no performance fee at all. (The situation is worse yet with hedge funds, which also have asymmetric fees but on a much larger scale.)

However, if fund investors lack the tool of performance bonuses, they can nevertheless avail themselves of the data on fund-manager ownership. The SEC requires that fund companies disclose how much money the portfolio managers have invested in the funds that they run. While I am somewhat skeptical of the value of this information--and have argued elsewhere that it is insufficient to motivate a significant change in behavior--I do not feel terribly strongly about that belief. I might be wrong. And certainly, a high level of manager ownership will not hurt. It is a neutral at worst.

A final item that Vanguard does not mention in the interview, but that the company certainly regards as important, is low portfolio turnover. Virtually without exception, Vanguard's actively run funds have lower turnover rates than the industry average. Trades mean trading costs--not brokerage fees, which are de minimis these days, but buy/sell spreads, which are and always have been meaningful. (For funds as large as Vanguard's, trades also can lead to pushing the security's price, which can be an even bigger drag on performance.) Vanguard's managers are chary about tinkering with their portfolios.

Et Tu, Vanguard?
I did another double take when seeing Vanguard's Friday press release announcing the registration of a new fund, Global Minimum Volatility. Low-volatility strategies are all the rage--all the rage not being a term that one normally associates with Vanguard fund launches.

In addition, low volatility is a variety of smart beta, an investment species that Vanguard regards skeptically. Vanguard does offer the very basic smart-beta flavors of small-company and value indexes, but it has eschewed other approaches of smart beta, such as fundamental indexing, equal-weighting, and momentum strategies. Vanguard's general argument is that investors are better off keeping things simple than trying to improve portfolios by choosing ever-thinner slices of the market.

Then I read the press release, and my confusion cleared. The fund might favor lower-beta, lower-volatility stocks, but even so, it's a very conventional fund. It will be a global-stock portfolio, with about half its assets in U.S. equities and half overseas. In addition to presumably choosing relatively defensive stocks, the fund will attempt to minimize price fluctuations by hedging most of its currency exposure. In other words, the fund will be a typical Vanguard offering: broad based and conservatively structured. It will be run by the company's active quantitative equity group.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.