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Vanguard’s Active Stock Funds Are Very Good

But, overall, Vanguard's index funds have been better.

Two Paths As funds to be stashed away for decades in tax-sheltered accounts, Vanguard's active stock funds are the equal of the company's index funds. That's impressive, particularly for such a giant organization. It's one thing for a boutique firm to compete effectively against the indexes while managing a limited product line; it's quite another for a mega-complex to accomplish the task.

However, many fund purchases are made under other circumstances than for a long, untaxed, period. Although shareholders may believe they will hold a fund indefinitely, market fluctuations can alter that viewpoint. (Collectively, investors looked out much further during the relative calm of December 2007 than they did a year later, following the disaster that was 2008.) Volatility matters. So do taxes, for those who hold assets in taxable accounts.

In the two areas of volatility and taxes, Vanguard's stock index funds have been slightly superior to its actively managed funds.

The Past Decade

Let's run through the numbers. First, total returns for the trailing decade: I've taken the performance from the oldest share class of all actively run Vanguard stock funds, domestic and foreign, that have Vanguard index fund competitors. (For example, I've excluded

Note that this is an investable comparison. Generally, actively run funds are measured against costless, theoretical indexes, rather than actual funds. Not this day! A Vanguard investor may select one of the company's actively managed stock funds or opt for an index fund that shares the same category. That is a real, ongoing choice.

Exhibit 1 shows the total return results, before taxes. On average, the 19 active funds trailed the index funds by 0.22 percentage points per year during the trailing decade. That amount, perhaps not entirely coincidentally, roughly matches the difference in expense ratios between the two groups.

- Source: Morningstar

It was close. In 11 of the 19 cases the index funds had the higher pretax returns; in the other eight, the active funds fared better. In only one instance--

The tightness of the contest owes to Vanguard's conservative management style. The company is careful about what active funds it offers and careful about how those funds are handled. They tend to be broadly diverse, often run by multiple investment managers, and have fairly strict risk controls that minimize tracking error. An actively managed Vanguard fund might well trail its benchmark, but it's unlikely to do so by very much.

A Bright Spot During the past five years, the active funds are the winners.

- Source: Morningstar

Again, Vanguard Capital Value lags by more than 2 percentage points, but this time the active funds more than compensate for that weakness by having two funds of their own outperform by more than 2 points, and a third approaching that mark. Overall, the active funds beat their indexed rivals by an annualized 43 basis points for the five years. It's not a particularly long time, but a pleasant achievement nonetheless.

The pattern of the index funds winning in one period, active funds winning in another, and the gap between the two groups being small goes back much further than 10 years. That was also the case in the 1980s, 1990s, and early into the new millennium. For pretax total returns, it's a wash: The company's active stock funds are as good as its index funds, and vice versa.

Ups and Downs However, the active funds have been more volatile. Although it's often said that active funds are safer than index funds (particularly by those who have active funds to sell) because the active funds have a cash cushion and can raise more cash as needed, the reality tends to be otherwise. The active funds tend to be somewhat bumpier because they are less diversified. They have fewer holdings, and they're more likely to concentrate into a few sectors.

Exhibit 3 shows the comparative standard deviations for the active and index funds. As before, the measurement consists of subtracting the appropriate index fund's total from that of the active fund, so a positive result indicates a higher figure for the active fund, and a negative result a higher figure for the index fund. But the interpretation of the results is reversed. This time, a higher number is bad.

- Source: Morningstar

Thirteen of the 18 funds were more volatile than their indexed rivals. With the exception again of Vanguard Capital Value, the margins were generally close, but higher is higher. That slightly elevated level of risk erases the return advantage that the active funds had for the five-year period. And it puts the active funds a bit further behind for 10 years.

The Taxman Cometh Taxes are another consideration. For the most part, Vanguard's actively run funds are relatively tax-efficient, as they have low turnover rates. (Turnover rates are only loosely correlated with tax efficiency, but there is a relationship between the two.) But it's very hard for active funds to match an index fund's efficiency. When the tax effects are calculated, using Morningstar's standard approach of the highest federal rates in existence at the time, the index funds extend their 10-year lead from 22 basis points to 34 basis points.

- Source: Morningstar

During the past several years, Vanguard's stock index funds have attracted huge inflows. Its actively run funds have been nowhere near as popular, but most have enjoyed some sales success, even as the rest of the industry suffers from outflows. That makes sense. One can quibble about the magnitude of the sales difference between the company's active and indexed stock funds, but not with the direction. Vanguard's stock index funds have made the strongest case for themselves. Its active funds have been close behind, and comfortably better than most of their fund-industry competitors'.

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.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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