Vanguard active funds beat indexes

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(MoneyWatch) Vanguard CEO Bill McNabb recently stated in a webinar that the financial giant's active stock funds have outperformed their respective indexes. This is supported by a recently released Vanguard paper, "The Case for Vanguard Active Management."

According to the paper, over the past roughly 30 years ending June 30, 2012, Vanguard active funds have outperformed their indexes by an average of 0.59 percent annually. This is after the fees charged and weighted according to the fund size, which translates to the returns investors actually received. As of Nov. 30, 2012, active funds represented about 26 percent of the $1.2 trillion of Vanguard stock fund assets.

I spoke with one of the paper's authors, Daniel Wallick, a principal in Vanguard's investment strategy group. He said that Vanguard's average active expense ratio over the period averaged 0.47 percent and currently averages 0.37 percent, lower than many industrywide index funds. The key to improving the odds of beating the benchmark were costs and talent, Wallick said. Industrywide, active funds in the lowest quartile as ranked by costs had a much higher probability of besting their benchmark, but even the lowest-cost funds bested the benchmark less than 40 percent of the time.

Free lunch?

Before you conclude that going with Vanguard active is superior to index funds, there are a few things to consider. First, Wallick was quick to point out that results varied within the time period studied and that one of the conclusions reached was that the investor had to be willing to stay with an active fund over long periods of time. Next, Wallick noted that the active funds were more volatile than the corresponding indexes. Some would say that this excess return was compensation for taking on more risk as measured by greater volatility. Thus, it wasn't excess return at all.

Finally, the paper examined returns after taxes. Unlike broad index funds, active funds buy and sell stocks that generate capital gains passed through to the fund owners and taxed by the IRS. That represented an extra cost estimated at 1.03 percent annually, while the broad index fund generated very little if any capital gains taxes. Wallick told me that "most of the time the Vanguard Total Stock Index Fund (VTSMX) bested the active U.S. stock funds on an after-tax basis."

It's fascinating that the firm that brought indexing to the public also has such a stellar record with its active funds. I thought the paper did a terrific job of comparing performance. It measured results using different methodologies and, according to some of these approaches the outperformance was less than the 0.59 percent noted above and even negative for some longer time periods. That, combined with the fact that taxes really do matter, leads me to conclude the broad index strategy is superior to Vanguard's active funds.

If you do go with some of Vanguard's active stock funds, consider locating them in a tax-deferred IRA or 401(k). That way the tax inefficiencies are eliminated. Make sure you are committed to staying in any active fund for the long-run. Performance-chasing rarely works. Finally, remember that the past outperformance is not a guarantee that even long-term future performance will best the benchmarks.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.