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Rekenthaler Report

Active Versus Passive Is the Wrong Question

The cost is what counts.

Succeeding in Silence
Two weeks ago I asked, Do Active Funds Have a Future? Several readers found that to be a silly question. There are good funds of each flavor, they argued. Rather than pit active funds against passive funds, I should distinguish between deserving funds and those that are not.

I agree.

That column discussed what is, not what should be. And what is, is a public relations thrashing. Index-fund managers have convinced the marketplace that the critical investment issue is whether to be passive or active. The triumph of indexing has become a familiar tale, detailed not only in The Wall Street Journal's Thursday feature on Vanguard, but again two days later in Jason Zweig's column. Active management is regarded as a losers' game.

That belief, however, is incomplete. It's true that active management sold at its customarily steep price is second-rate. But so are high-cost index funds. (There are more of them than you would think, although most such funds have few assets.) How a fund is managed is less important than its cost headwind.

To test the proposition, I sorted active U.S. diversified-stock funds into two groups: the very cheap and the expensive. Funds in the first group have current annual expense ratios of no more than 0.50%, while those in the second have expense ratios of at least 1.50%. Several of the discount funds were offered by Vanguard; I set those aside into a new pool, to be measured separately. Finally, I discarded DFA's funds. They appear in Morningstar's database as active funds, because they must be somewhere, but in reality they straddle a middle ground. They do not belong with active funds for the purpose of this test.

That made for three comparison groups for active funds: 1) Vanguard, 2) not from Vanguard but priced like Vanguard, and 3) expensive. To those three groups, I added a fourth group of Vanguard index funds. I then calculated the average total-return rank for each group, as compared against other funds of the same category, over the trailing 15 years.


  - Source: Morningstar Data.

Quietly, Vanguard's actively run funds have outperformed their more-famous index siblings. The very cheap active funds from other companies were somewhat behind Vanguard's active offerings but were fully competitive with the company's index funds. The costly funds lagged significantly, as expected.

The index funds' average ranking of 44 may strike you as unimpressive. If so, that is partially because you have been oversold by index marketers, who like to imply that actively run funds outgain indexes over the long term as often as metal scavengers find long-forgotten gold hoards. The occasion is not nearly so rare. But there is also a legitimate explanation: Every Vanguard index fund from 15 years ago exists today, where as many losing competitors closed their doors and thus do not appear in this study. Vanguard's index funds compete against the winners.

This includes Vanguard's active funds, several of which were merged or liquidated during the period. Thus, I hesitate to declare victory in this contest for either Vanguard's group of active funds or for the larger pool of non-Vanguard funds. While some active fund families rarely if ever kill their babies (for example, American Funds), the practice is prevalent enough such that one must be wary when comparing live funds against live funds. Nonetheless, even assuming that each of Vanguard's merged or liquidated funds was a relatively poor performer, the active funds held their own. 

Which raises the question: What about the other major investment areas? 

I first looked at allocation funds--A after all leading the alphabet--eliminating target-date funds because there aren't true target-date index offerings. (There is no target-date "marketplace" for indexes to emulate.) There was a slight advantage for active funds, with to my knowledge one active fund disappearing during the time period (Growth Allocation). The number of funds of each type is given in the chart; obviously, in this case it is a very small sample size indeed for the passive group!


  - Source: Morningstar Data.

Next, I looked at international-stock funds. The advantage was larger here. In this case, an index fund has disappeared (Developed Markets Index). 


  - Source: Morningstar Data.

With taxable-bond funds, the indexes comfortably won the contest. But the active funds were plenty good. 


  - Source: Morningstar Data.

One may object that Vanguard's active funds assume more risk. I don't believe that to be the case. Often, actively managed funds outgain indexes by taking on more risk, but Vanguard would not seem to be that situation. The company's actively managed funds are run cautiously, often diversified among multiple managers.

Another objection is that while the averages may sort themselves out for active management, investors do not earn an average. They earn the return from a single fund, the performance of which is not known in advance. Thus, index funds are more attractive because they do not deliver surprises, whereas the unlucky active investor could land a spectacular dud. This is a stronger argument, as evidenced by the case of the disappearing active Vanguard U.S. stock funds. 

Certainly, this is far from the final word on the subject. Different time periods could be used, different measures of success, different groupings. But it seems unlikely that these changes would put very cheap active funds and very cheap passive funds (after all, this column didn't use just any index funds, it used the funds from the world leader) very far apart. Both species of funds figure to fare well. The question is, will active management heed the call? 

Edit: This is a revised version of the column. The first version stated that Vanguard had not merged or liquidated any of its active U.S. stock funds. The text in several places was altered to correct that error.

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.