How to Block Out the Noise in Fund Returns

One of the most popular funds around had very humble beginnings. It did a pratfall out of the gate, and its return for the three-year period through the end of 1979 ranked in the bottom 15% of its category. Yet it later went on to big things. In the 1980s it outperformed its peers in eight out of 10 calendar years, and in the 1990s it did the same in seven out of 10. So far this decade it has outperformed in two out of three years, and its trailing 10-year returns rank in the top 20% of its category.

So, you may ask, how did they turn it around? A new manager? A better strategy? Nope, they just kept doing what they had been all along.  Vanguard 500 Index (VFINX) buys the stocks in the S&P 500 Index and then holds on until the Standard & Poor's Index Committee tosses something out. The fund’s advantage versus the competition is constant: It has lower expenses than nearly every other fund around. This advantage works equally well year in and year out, and over time it builds to something impressive.

Even so, this fund will experience some sizable swings in relative performance. It and other index funds serve as an interesting control group for evaluating the performance of active and passive funds alike. They remain constant so the changes in performance largely owe to market noise, as different sectors and parts of the style box heat up or cool off.

In the case of Vanguard 500, much of the shifts in its returns relative to other large-blend funds can be attributed to its large market capitalization. The S&P 500 has a geometric mean market cap of about $51 billion; nearly 90% of large-blend funds have a lower market cap. In fact, the late 1970s were dominated by small caps, so it’s understandable that the fund underperformed. Likewise, the fund’s best three-year run came in the 36 months ending in April 1999, when it trounced 93% of its category peers thanks to a period of large-cap outperformance.

If you evaluate the fund over five-year stretches, there’s less noise but it isn’t absent. The fund was just a hair above the bottom decile for its worst five-year stretch and in the top 5% for its best. The story for  Vanguard European Equity Index (VEURX) is fairly similar.  Vanguard Total Bond Market Index’s (VBMFX) worst five-year period wasn’t as bad as Vanguard 500’s. Its worst stretch was just slightly below average. That makes sense because bond fund returns are tightly bunched, and expenses have a bigger impact on bond funds' short-period performance rankings than they do on stock funds'.

What to Do about Noise in Total Returns
So, what this tells you is that there’s a lot of noise in even three-year numbers. If you’re evaluating an active manager, you shouldn’t overreact to swings in three-year numbers. There’s still good information there. If there are some serious fundamental problems that coincide with a drop in returns, you might want to get out. But if the fundamentals--such as management, strategy, and asset size--haven’t changed, you might be better off holding on.

Fundamentals tell you something about where the fund is headed rather than where its been. Look for low expenses, good management, and a sound strategy. When looking at returns, look for a fund that consistently outperformed rather than one that tops the charts. Consistent outperformance indicates that management can repeat its past success.  Dodge & Cox Income (DODIX) is an example of a great fund that just modestly beats its peers over short periods, but it’s so consistent that it is able to string together a number of those periods to produce strong long-term returns. Finally, the longer the record the better. When possible, look for strong 10- and even 15-year relative performance.

An Aside about Active versus Passive Funds
I frequently read news stories that claim the current year has been good or bad for actively managed funds relative to passively managed ones. Inevitably, it turns out that the writer has come to this conclusion by comparing the returns of Vanguard 500 with those of all domestic-stock funds. As I noted above, Vanguard 500 has a heavier weighting in the  General Electrics (GE) and  Ciscos (CSCO) of the world than even other large-cap funds. When you throw in the funds from all the other domestic-stock categories, all you are measuring is the effect of market cap on fund performance--not active versus passive. If you want to accurately measure how the two camps are doing, you should look at the relative performance of the biggest index fund in each category. Of course, the story is much less dramatic there, so it makes it harder for folks to proclaim a stock-picker’s market.