Vanguard Index Mutual Funds Versus Vanguard Managed Funds

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This two-part article:

1) summarizes a recent research report that compared Vanguard’s passively managed with Vanguard’s actively managed (The title of this study by Abel Rodriguez and Edward Tower is “Do Vanguard’s Managed Funds Beat Its Index Funds?” provide links to it below. If you invest in any of Vanguard’s investment fund products, I recommend that you read and understand this study.)

2) discusses an email promotion for an investment newsletter, which claims that it has consistently out-performed and will continue to out-perform Vanguard’s passively managed . (This email solicitation came from Dan Wiener, the editor of The Independent Adviser for Vanguard Investors.)

Use a very low cost, fully passive, and globally diversified investment strategy

Neither this study nor this investment letter email promo has changed my fundamental investment viewpoint, which I summarized in the subheading just above. I strongly advocate to my readers and to financial planning clients that they use an investment fund based strategy that is very low cost, fully passive, and globally diversified. The Rodriguez-Tower study enriched my understanding of Vanguard’s mutual fund offerings and strengthened my convictions. On the contrary, Dan Wiener’s investing newsletter promotion was not terribly enlightening.

Regular readers of my Family Finances articles know that I consistently advocate a very low cost, fully passive, and globally diversified investment strategy for an individual investor’s personal portfolio. Therefore, I will not repeat my reasoning in this article regarding this investment strategy recommendation.

Instead, I will refer you to these articles, which have previously been published on my Family Finance site. In particular, see these articles:

I am also a regular, avid reader of the Journal of Indexes, which you too can read at Index Universe is a content rich website for index investors, and the Journal of Indexes is one of the few financial publications that I consider to be “must reads.” In its March/April 2008 issue, which was entitled “Active vs. Passive 2.0,” the Journal published an enlightening article entitled: “Do Vanguard’s Managed Funds Beat Its Index Funds?

Do Vanguard’s Managed Funds Beat Its Index Funds?

“Do Vanguard’s Managed Funds Beat Its Index Funds?” was co-written by Abel Rodriguez, now Assistant Professor of Statistics at the University of California Santa Cruz and by Edward Tower Professor of Economics at Duke University. Their paper in the Journal of Indexes was based on Abel Rodriguez’s master’s thesis at Duke, which Professor Tower supervised. This investment research journal article was further developed by Rodriguez and Tower, as Rodriguez worked on his PhD in statistics at Duke.

I was particularly interested in this analysis, because of what I might learn about passive index investing and active management comparisons at the portfolio level, which is what counts in personal investment management. More so than any other investment fund company, The Vanguard Group has offered a very wide array of passive index funds for many years. More recently, they have also offered more actively managed , albeit still with very low costs. Additionally and more recently, Vanguard has introduced an array of index ETFs. While actively managed, Vanguard’s managed funds have management expense ratios, which are far below averages for other competitive funds in the mutual fund industry.

Active mutual fund managers simply do not earn their management expense ratios and transactions costs

Briefly, the problem with active management is that, while professional investment managers have been show to demonstrate a modest average level of skill (see in particular, research by Wermer, et. al.), unfortunately their management expense ratios are much higher than their apparent skills. On average, the excessive management expenses of active money managers are over double the value of their incremental performance gain. This, of course, wipes out any incremental performance advantage that professional money managers might provide, if direct portfolio management expenses were all that you considered.

Other factors further complicate the active investment fund cost situation. First, except for choosing very low cost funds there is no reliable way to discern beforehand which manager might out perform another to justify his high fee. Second, mutual fund transactions costs roughly are roughly equal an active mutual fund’s management expense ratio. The more active the fund and the higher the turnover, the greater the transactions costs

Excessive costs and the inability to identify reliably supposedly superior money managers before the fact, creates a compelling financial logic for the individual investor. To improve your net investment performance, you are compelled to move to the low cost end of the mutual fund and ETF spectrum. When you do this, you must also more to the completely passive, indexed end of the product spectrum.

In this process, you soon realize that only Vanguard, Fidelity, and a handful of other investment fund companies offer very low cost investment funds. All the rest of the fund families seem to present their clients with a beat-the-market, 4-star and 5-star fund, superior performance hustle. Of course, securities markets are the great levelers. Some funds will win and others will lose. Over time most winners become losers and vice versa. For decades, this game has been is been very good for the shareholders of the mutual fund companies and not so good for shareholder-investors within these actively managed funds.

Vanguard’s Low Cost Index Mutual Funds and Vanguard’s Managed Funds

This “Do Vanguard’s Managed Funds Beat Its Index Funds?” investment research article offered an opportunity to understand in more detail the trade offs between active and passive mutual fund management within the overall Vanguard product family. To summarize the major conclusions of this study very briefly (It is worth you reading it yourself!), the study generally concluded that over the four year 2003 to 2006:

  • Vanguard’s passive index funds beat Vanguard’s actively managed funds, when there was a relatively close investment style benchmark between passive and active funds. Rodriguez and Tower said “investors would be well-advised to buy index funds instead of managed funds in situations where those funds closely track their index fund baskets.” (p.31)
  • When all passive index funds and actively managed funds were combined into separate portfolios, over these four years, the managed portfolios had “an average out performance of .46%, which was not statistically significant. Much of this differential was explained by the extraordinary performance of the Vanguard International Explorer, Capital Opportunity, and Primecap funds.” (p.29) In essence, this did not prove or disprove the active versus passive question analyzed within the context of Vanguard’s fund offerings. There simply seemed not to be any comparable Vanguard index funds for comparison. Rodriguez and Tower observed that “when managed fund performance is not well explained by a tracking index fund basket, investor may look toward the managed funds.” (p.31)
  • Vanguard managed funds were more risky in general, and their managers did not make prescient style adjustments, as market returns for different investment styles (e.g. growth versus value) fluctuated.
  • Also, quoting this study, “the managed funds on average have expense ratios that are .26% greater than their corresponding tracking index. They also had turnover rates that are 33% greater than the tracking index.” (p.31) It is critical to realize that Vanguard’s managed funds really are very low cost managed funds. Industry averages for actively managed mutual fund management expense ratios are about twice as high or more. The higher the costs and the greater the turnover, the more ground an expensive, high turnover actively managed mutual fund has to cover just to break even with their lower cost, passive index competitors.

To conclude summary of this investment research paper, I would also like to point the reader to some discussions of this paper on Internet forums. Unlike many discussion forums, which often devolve into unproductive emotionalism and bickering, these forum discussions of this research study really are quite informative.

In addition, Professor Tower has participated in these forums, and he used these discussions as a sounding board for ideas and as a means to clarify certain aspects of this study. I recommend these forum conversations to anyone who has or intends to hold a significant portion of his or her personal investment asset portfolio in Vanguard’s index funds, managed funds, and/or ETFs. Use these links to find these forums:

The historical investment performance record of Dan Wiener’s Growth Portfolio

Along with introductory quotations from Paul Merriman and John C. Bogle, the “Do Vanguard’s Managed Funds Beat Its Index Funds?” investment research paper also included an introductory quotation from Dan Wiener. Dan Wiener publishes and promotes an investing newsletter called The Independent Advisor for Vanguard Investors.

Dan Wiener’s quote in the Rodriguez-Tower paper accused Vanguard of lying to its customers, delivering inferior performance with its index funds, and exposing its fund shareholders to the “worst risks of bear markets.” (p.27) When I first read this research paper, I was curious about why the Rodriguez-Tower investment research study even needed to include these comments by Dan Weiner. Also, I wondered why his comments needed to be so incendiary. However, I did not pay much attention to these statements, because they were largely peripheral to the main analysis of the Rodriguez and Tower study.

Near the conclusion of their investing research paper, Rodriguez and Tower briefly addressed the performance of Dan Wiener’s Growth Portfolio. Apparently, Dan Wiener’s mutual fund newsletter has been a strong advocate of using Vanguard’s managed fund offerings. Furthermore, it seems that his newsletter focuses solely upon investing strategies that can be implemented with Vanguard’s passive index funds, actively managed funds, and ETFs. As I understand it, Dan Wiener’s The Independent Advisor for Vanguard Investors investing strategy newsletter does not provide alternative fund recommendations from any other mutual fund companies.

In their study, Rodriguez and Tower stated that Dan Wiener’s Growth Portfolio had demonstrated performance over the prior nine years that outperformed the Wilshire 5000 index by 5.44% annually. Since January of 1992 or over about 16 years, the Growth Portfolio from this personal investing newsletter apparently had delivered average annual returns that were 2.27% greater than the Wilshire 5000 index. In addition, portfolio risk also seemed to have been lower.

Using The Hulbert Financial Digest and the Wilshire 5000 to benchmark Dan Weiner’s historical Growth Portfolio performance

Dan Weiner’s Growth Portfolio performance was not central to the analysis of the Rodriguez and Tower study. Instead, they briefly commented on it, after they had finished the presentation of their study methodology and results, and they were wrapping up their paper. Rodriguez and Tower used separate data that they obtained from The Hulbert Financial Digest, which is an evaluator of investment newsletter performance.

With The Hulbert Financial Digest data, they commented that the 16 years of 2.27% average out-performance of Dan Weiner’s Growth Portfolio was statistically significant at the 13.4% confidence level using a standard t-statistic test. The t-statistic test is a very limited statistical test, and it is used when there are too few data points to use other more robust statistical tests. The t-statistic test simply measures the likelihood of that the average or mean of one small data set is different than the mean of another data set due to something other than simple randomness.

In essence, a 13.4% confidence level implies that there is about a 1 in 12 chance that the difference was purely random rather than likely being due to some other non-random cause or causes. In this case, the non-random cause could be investment skill, lack of comparability of Dan Wiener’s Growth Portfolio and the Wilshire 5000, and/or some other controllable or uncontrollable influence. A t-statistic test makes no judgment about the magnitude or cause of any differences. A t-statistic test compares the averages sparse data sets. A t-statistic test is historical in nature and not predictive.

Someone might be tempted to construe this 13.4% statistical confidence level as evidence of investment skill on the part of Dan Weiner. However, it is also important to point out that standards of statistical proof in investment, economics, and other social sciences research papers almost invariably require a 5% (a 1 in 20 chance) or even 1% (a 1 in 100 chance) confidence interval. In thirty years of reading statistical research papers, I have never seen a peer-reviewed statistical research paper where the author considered that a statistical hypothesis had been proven, when the data did not achieve even a 10% confidence level (or a 1 in 10).

Finally, given the core findings of the Rodriguez-Tower study and Dan Weiner’s apparent Growth Portfolio results, it is interesting to speculate about the source of any out-performance. Since Rodriguez and Tower gave the advantage to Vanguard’s lower cost passive index funds when a more expensive index fund more closely tracked the benchmark, out performance would likely come from another source. One candidate explanation would be to weigh heavily higher growth funds that lacked a passive index counterpart, such as Vanguard Capital Opportunity, International Explorer, and Primecap. Another would be to question whether the Wilshire 5000 was an appropriate benchmark, especially if the source some of these apparently superior returns was international.

I do not know the answer, because the Rodriguez-Tower study only took a cursory look at Dan Weiner’s Growth Portfolio results. Nevertheless, findings of the Rodriguez-Tower study Dan Weiner’s Growth Portfolio results remain anomalous. There seems to be some skill or luck and/or some inappropriate benchmarking going on someplace.

Superior investment performance results, investment costs, taxes, and selective marketing

Despite the previous discussion, let us be gracious and assume that the Dan Wiener finance newsletter performance data are accurate and furthermore let us also assume that that the Wilshire 5000 is an appropriate benchmark for a Growth Stock index. Granting this, then a 2.27% average annual incremental advantage – skill based or luck based – would yield about 43% more in gross assets over 16 years, if the baseline index did not grow over this period. (This ratio would shrink slightly depending upon the growth rate of the benchmark index. If the benchmark index grows 10% annually, then 2.27% incremental growth or 12.27% total annual growth yields a 39% advantage.)

However, since this performance advantage comparison is made with an index without management expenses or taxes. Therefore, the percentage performance advantage above would need to be reduced to the extent that investment expenses and investment taxes were incurred. Therefore, the supposedly superior, skill based performance results of Dan Wiener’s investment letter’s Growth Portfolio may not be all that they might seem.

In addition, the securities and financial services industry has turned selling of superior performance and a “beat the market” strategy into an art form. Unfortunately, millions of individual investors fall into the financial industry’s “we will do better for you” trap. So very few individual investors track carefully their actual results over the long term to see how well or poorly they actually have done relative to a broadly diversified, very low cost, passive index investment strategy. (See: What is the cost to individual investors of sub-optimal portfolio diversification? on The Skilled Investor website.)

One of the tactics employed by financial promoters is to selectively market only those financial products that have demonstrated supposedly superior performance, while downplaying their mediocre funds and sweeping their laggards under the rug. Instead of providing more details about the marketing games here, instead, I will refer you to some articles on our sister website. See these articles and use the links within them to find more articles that discuss selective investment fund marketing and investment luck versus skill:

In the case of Dan Weiner’s Growth Portfolio historical out-performance of the Wilshire 5000 index, there might be a bit of selective marketing going on here. Dan Weiner also has three other portfolios that he promotes in his investment newsletter, “The Independent Advisor for Vanguard Investors.” The Hulbert Financial Digest analyzes investment newsletters, and it tracks the performance of Dan Weiner’s four portfolios. The Hulbert Financial Digest analyzed Dan Wiener’s four investing newsletter portfolios with the portfolios of other investor newletters.

In footnote #15 of their study, Rodriguez and Tower commented on information this information from The Hulbert Financial Digest, saying “Wiener’s Growth Portfolio performed better over the 10 years ending December 2006 on both a risk-adjusted and a non-risk-adjusted basis, that his other three portfolios. The odds that one of his portfolios would perform well due to luck are greater than the odds that one particular portfolio will perform well, so arguably our 13.4% figure in the text overstates his portfolio-picking prowess. The March 2007 edition of The Hulbert Financial Digest lists the Wiener newsletter as fifth out of 24 mutual fund newsletters on the basis of total return and tenth out of 24 on the basis of risk adjusted return.” (p.58)

Does Vanguard discriminate against its passive index fund investors, Dan Weiner suggested? Rodriguez and Tower also addressed Dan Weiner’s accusation that Vanguard in some way discriminated against its managed fund customers to favor its index fund clients. Rodriquez and Tower analyzed this and found no data to support this charge.

Finally, Rodriguez and Tower looked at Dan Weiner’s early 2007 buy, hold, and sell recommendations. They said that “we find those managed funds that he (Weiner) rates buy, hold, and sell have average geometric alphas [presumably skill based performance differences] for the four year period of +1.39 percent, -0.83 percent, and -1.66 percent per year, respectively. Thus, his recommendations are consistent with our alphas.”(p.34) Also, given these numbers, it would seem that Dan Weiner’s recommendations could be consistent with trend extrapolation. In essence, he recommended managed funds that had out-performed over the four years from 2003 to 2006 and advised against Vanguard managed funds that had underperformed during this same period.

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