Has Vanguard Added Value as an Active Manager?

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1 Has Vanguard Added Value as an Active Manager? January 12, 2016 by Larry Swedroe Passive management was pioneered by Vanguard, and its founder, John Bogle, remains its most outspoken advocate. But the firm also offers actively managed funds. Have they added value relative to its passive counterparts? I ll continue my series today on the performance of some of the market s most prominent actively managed mutual fund families with a look at the actively managed mutual funds offered by Vanguard, the largest fund family with assets under management approaching $3 trillion. While the huge amount of assets under management alone makes Vanguard an interesting case, there are three other important reasons for examining it. In addition to offering actively managed funds, it s also the market s largest provider of index funds. Vanguard s unique ownership structure (the investors in its funds are its owners) allows them to offer actively managed funds with much lower costs than those offered by its competitors, reducing the hurdle for active managers in their quest for alpha. Third, their actively managed funds tend to exhibit lower turnover than the typical actively managed fund. The higher costs associated with implementing active strategies are the reason there s an overwhelming body of evidence demonstrating that active management is a loser s game. It s one that is possible to win, but the odds of doing so are so poor that it s not prudent to try. In fact, academic studies have shown that on a gross basis, before considering their expense ratios and trading costs, active managers do generate alpha. As is my practice, in order to see how well Vanguard s actively managed funds have performed for their investors, I will compare the results of its actively managed equity funds both to those of its own index funds and to the passively managed funds of Dimensional Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) In addition, DFA funds can be purchased through some 529 and 401(k) plans, but generally they are available only through an advisor. An investor would incur fees from that advisor; those fees vary greatly (in some cases they are very low) and cover the full range of financial planning services provided by the advisor. Also, John Hancock recently introduced a series of ETFs that are managed by DFA (with expense ratios that differ from the DFA funds cited in this article). Those ETFs can be Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 purchased directly by investors. All Vanguard funds can be purchased directly by investors. To keep the list to a manageable number of funds and to ensure that I examine long-term results through full economic cycles, I ll analyze the 15-year period ending September 30, Furthermore, when there is more than one share class of fund available, I will use the lowest-cost shares that were obtainable for the entire period. In the cases where Vanguard has more than one fund in an asset class, the average return of those funds is used in the comparison. The table below shows the performance data for 14 actively managed funds offered by Vanguard in five domestic asset classes and two international asset classes. s are placed in a given asset class based on Morningstar s style categorization. October 2000-September 2015 Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 Symbol Expense Ratio Annualized Return U.S. Large Cap Blend Vanguard Dividend Growth VDIGX Vanguard Growth and Income VQNPX Vanguard Average DFA U.S. Large Company Portfolio DFUSX Vanguard 500 Index VFINX U.S. Large Growth Vanguard Capital Opportunity VHCOX Vanguard MorganTM Growth VMRGX Vanguard PrimeCap VPMCX Vanguard U.S. Growth Portfolio VWUSX Vanguard Average Vanguard Growth Index VIGIX U.S. Large Value Vanguard Equity Income VEIPX Vanguard U.S. Value VUVLX Vanguard WindsorTM II VWNFX Vanguard WindsorTM VWNDX Vanguard Average Vanguard Value Index VIVIX Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 DFA U.S. Large Cap Value III Portfolio DFUVX U.S. Mid Cap Blend Vanguard Strategic Equity VSEQX Vanguard Mid Cap Index VSCIX U.S. Small Cap Growth Vanguard Explorer VEXPX Vanguard Small Cap Growth Index VSGIX Foreign Large Value Vanguard International Value VTRIX DFA International Value III Portfolio DFVIX Foreign Small Cap/Mid Cap Blend Vanguard International Explorer VINEX DFA International Small Company PortfolioDFISX The following are the most important takeaways from this data: In the four asset classes for which there are comparable DFA funds, the Vanguard active funds outperformed in one. In the five asset classes for which there are comparable index funds from Vanguard, the firm s active funds outperformed in four. A portfolio of Vanguard s actively managed funds, equal-weighted in the four asset classes for which there are comparable DFA funds, returned 5.4% a year. The average expense ratio was 0.38%. An equal-weighted portfolio of DFA funds in the same four asset classes returned 6.6% a year, outperforming the comparable Vanguard portfolio by 1.2 percentage points a year. The DFA portfolio s average expense ratio was 0.25%. The underperformance of the Vanguard actively managed portfolio was well in excess of the difference (0.13 percentage points) in the average Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 expense ratios. In the five asset classes for which comparable Vanguard index funds are available, an equalweighted portfolio of Vanguard s actively managed funds returned 5.9% a year. The average expense ratio was 0.39%, well below the expense ratio of the typical actively managed fund. An equal-weighted portfolio of Vanguard index funds in the same five asset classes returned 5.6% a year, underperforming the actively managed portfolio by 0.3 percentage points a year. The Vanguard index fund portfolio s average expense ratio was 0.08%. Vanguard s actively managed funds were able to outperform despite the disadvantage of an expense ratio 0.31 percentage points higher. If this were a prizefight, we d declare it a draw. While a portfolio of Vanguard s actively managed funds did outperform a portfolio of its index funds by 0.3 percentage points a year, it underperformed a comparable DFA portfolio by 1.2 percentage points a year. Factor analysis I ll now take another look at the performance of the 12 actively managed domestic funds from Vanguard included above using the analytical tools and data available at Portfolio Visualizer. Factor analysis provides important additional insights into a fund s performance because Morningstar asset class categories are very broad and actively managed funds can style drift. The table below shows the results of the three-factor (beta, size and value), four-factor (adding momentum) and six-factor (adding quality and low beta) analysis for the firm s U.S. funds. The data covers the period from October 2000 through September Each t-statistic is in parentheses. October 2000-September 2015 Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.

6 Symbol Three-Factor Annual Alpha Four-Factor Annual Alpha Six-Factor Annual Alpha Vanguard Dividend Growth VDIGX 1.3 (0.9) 0.9 (0.9) -0.4 (-0.2) Vanguard Growth and Income -0.2 VQNPX (-0.5) (2.0) Vanguard Capital Opportunity 2.1 VHCOX (1.4) 2.0 (1.3) 2.8 (1.7) Vanguard MorganTM Growth -0.4 VMRGX -0.1 (-0.1) -0.4 Vanguard PrimeCap 2.2 VPMCX (1.9) 2.1 (1.8) 2.6 (2.1) Vanguard U.S. Growth Portfolio -2.2 VWUSX (-2.6) (-1.2) Vanguard Equity Income VEIPX 2.4 (2.6) 2.6 (2.7) 1.0 (1.0) Vanguard U.S. Value VUVLX 0.9 (1.0) 0.6 (0.7) -0.9 (-1.0) Vanguard WindsorTM II 1.4 VWNFX (1.4) 1.4 (1.5) -0.4 Vanguard WindsorTM 1.0 VWNDX (1.0) 1.4 (1.3) 0.0 (0.0) Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.

7 Vanguard Strategic Equity VSEQX 1.0 (0.6) 0.2 (0.1) 0.9 (0.0) Vanguard Explorer VEXPX -0.2 (-0.2) -1.1 (-1.0) -1.1 (-0.9) Average Alpha When we examine the results from the three-factor analysis, we find that eight of the 12 Vanguard funds generated positive alphas, with the average annual alpha coming in at 0.8%. Only two of the 12 funds showed statistically significant alpha at the 5% level, one being positive and the other being negative. When we look at results from the four-factor analysis, we again find that eight of the 12 Vanguard funds generated positive alphas. The average annual alpha was slightly smaller at 0.6%. One of the 12 funds showed statistically significant positive alpha at the 5% level. When we include all six factors in our analysis, we find that just four of the 12 Vanguard funds now showed positive alphas. The average annual alpha, however, was still positive at 0.1%. To summarize, Vanguard s actively managed funds compare favorably not only with the performance of the typical active fund, but also with the performance of the firm s own index funds. On the other hand, even though the sample we have is small (just four funds) Vanguard s actively managed offerings did underperform comparable DFA funds. The conclusion you should draw is that, if you are considering using actively managed funds, you should strongly emphasize relatively low expense ratios and relatively low turnover as selection criteria. Doing so will increase the odds of generating alpha. Reviewing results This is the 13th article in my series reviewing the performance of some of the market s leading mutual fund families. The table below shows the performance of the portfolios I ve constructed in my analyses for each of the fund families I ve examined relative to the performance of comparable portfolios from Vanguard and DFA, as well as results from each factor analysis. With TIAA-CREF, I did not originally perform the factor analysis. Thus, this data wasn t in the initial article. However, I ve now added that data, so we have the same analysis for all 13 fund families. Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.

8 Family Portfolio Return Versus Vanguard Portfolio Return Versus DFA Three-Factor Average Alpha Four-Factor Average Alpha Six-Factor Average Alpha TIAA- CREF Goldman Sachs JPMorgan Chase American s Gabelli s Waddell & Reed John Hancock Morgan Stanley Wells Fargo Russell SEI Hartford[1] Vanguard Average The following are some highlights from the table: Page 8, 2018 Advisor Perspectives, Inc. All rights reserved.

9 Of the 13 actively managed fund family portfolios, just four (including Vanguard) outperformed their comparable Vanguard index portfolios, and in one case that outperformance was just 0.1%. The average for all 13 was an underperformance of 0.3%. Active management was a loser s game; only a minority of fund families won. Compared to the DFA portfolios, just one actively managed fund family was able to outperform, and that was by the very slimmest of margins, only 0.1%. The average underperformance for all 13 was 0.9%. The three-factor regressions produced an average alpha for the 13 active fund families of -0.1%. The four-factor regressions produced an alpha of -0.2%. And the six-factor regressions produced an alpha of -0.9%. The only actively managed fund family in the group that added value when compared to both Vanguard index funds and DFA (though in this case by only the smallest of margins) was American s. American s also showed positive alphas relative to each of the factor regressions. Vanguard s actively managed funds outperformed its own passive funds, but underperformed the DFA portfolio by an amount four times greater. The firm s active funds posted positive alphas relative to each of the factor regressions as well. The Waddell & Reed funds also showed positive alphas relative to each of the factor regressions, but their funds underperformed comparable passive portfolios from both Vanguard (by a small amount) and DFA. Disclosure: The included data and analysis is a summary of 12 other pieces related to an ongoing series evaluating actively managed mutual fund families. For a complete list of those pieces, click to search Larry Swedroe at: The corresponding portfolios are provided for informational purposes only, were constructed specifically for this review and are not portfolios that Buckingham recommends. The returns data included is from Morningstar, and the factor analysis tool was provided by Portfolio Visualizer: Performance is historical and does not guarantee future results. Information from sources deemed reliable but its accuracy cannot be guaranteed. It should not be assumed that any of the securities listed were or will prove to be profitable. [1] This article was not published by Advisor Perspectives and appeared on another site. It can be viewed here. Page 9, 2018 Advisor Perspectives, Inc. All rights reserved.