The Vanguard S&P 500 index fund (VFIAX) has had an average annual expense ratio of 0.091 percent over the past ten years. Curiously, this fund has made up most of its expenses by outperforming the total return of the S&P 500. Rather than underperform by 0.091 percentage points annually, it has averaged only 0.016 percentage points short of the benchmark each year for the past ten years. Thus, before costs, it has bested the index total return by 0.075 percentage points annually. This is known as positive excess return, commonly referred to as positive tracking error. But was it luck or skill that caused this?
A little background
Early this year, a Bogleheads member alerted me to a podcast from prominent advisor Ric Edelman in which he accused this Vanguard fund of hiding 1.40 percentage points of annual costs. If this were true, then the fund should have underperformed the index total return by about 1.49 percentage points a year. As mentioned, the fund actually only lagged by 0.016 percentage points and Edelman removed the claim from his podcast.
How could Vanguard make up most of these costs?
I contacted Gus Sauter, Vanguard's Chief Investment Officer, who noted that the two areas where the fund could make up ground versus the index were through the uses of futures and securities lending.
Financial markets are not always perfectly efficient and sometimes the price of an S&P 500 futures contract is ever so slightly more attractive than the basket of 500 stocks itself. Vanguard buys the futures with new money when this is the case.
Next, like most large fund families, Vanguard lends out some of its securities to others, taking 102 percent collateral in cash. Vanguard then takes the profits and distributes them to the shareholders in the form of an increased net asset value. The borrowers of these securities need them to cover short positions.
Sauter stated that the impact from the futures was much greater than the impact from the securities lending.
Luck or skill?
When I pointed out the positive tracking error to Edelman, I asked him whether he thought it was luck or skill. He responded by saying "I think it's luck, due to the tracking error. It could just as easily have been wrong in the other direction - and at times, I'd bet it would be." I recently asked him to elaborate, but he did not respond.
Advisor and author William Bernstein also weighed in on the issue for me. He took this data and ran a statistical analysis that produced a "t-stat" showing there was more than a 95 percent probability this wasn't the random luck Edelman claimed. Bernstein did note, however, that the extra return might be compensation for taking on a miniscule amount of counter party risk. This means the parties on the other side of the futures or securities lending could default.
Edelman's accusation of Vanguard hiding costs led to a valuable finding. Vanguard has actually made up most of the costs they fully disclose. I'm going with Dr. Bernstein's statistical test showing the likelihood of luck being quite low. To put another nail in the coffin of Edelman's luck hypothesis, the fund has only lagged the S&P 500 total return by 0.01 percentage points for the first half of 2011. It again made up most of its expense ratio, now down to 0.06 percent annually.
It's fascinating that Vanguard, the firm that popularized indexing and the efficient market, is one of the few fund firms that manages to successfully exploit small market inefficiencies. So rather than hiding costs, Vanguard is disclosing costs the shareholder isn't totally paying. There is no guarantee that it will continue but I'd bet Edelman it will over the next ten years.