Markets

Vanguard's Case That Passive Management Works

By Larry Swedroe

Updated on: September 10, 2010 / 5:50 PM EDT / MoneyWatch

This article is a follow-up to my post on Vanguard suggesting that active management may be appropriate for investors. You can read Vanguard's response to the post in the comments section.

Judging by the comments on my last post, as well as comments on the Bogleheads forum, many people took issue with me suggesting that Vanguard had entered the world of investment porn. Simply put, I was surprised that Vanguard would suggest that active management may be a good strategy, given its own evidence against such a claim.

In December, Vanguard published an article that looked at how active management fared during two periods when it should perform best (according to active management proponents):

During a bear market, when active managers can get out of stocks to prevent losses.
During a stock picker's market, when stock returns are widespread and performance isn't positively correlated.

Vanguard's evidence showed the failure of both these theories to hold up in the real world. On the bear market theory, Vanguard found that in the seven bear markets since 1971, active managers outperformed the market only twice. Evidence such as this cause Vanguard to conclude that: "Given the difficulty of market-timing and the challenge of overcoming active funds' higher costs over the long term, Vanguard research concluded that an investor using index funds or ETFs was not at a disadvantage when investing in bear or bull markets."

Regarding a "stock pickers market," it looked at the first nine months of 2009 and noted that active managers actually fared well, with 62 percent outperforming the broad U.S. stock market. However, a closer look was needed. Vanguard broke out active managers into their appropriate styles, such as small-cap value or mid-cap growth. When compared to appropriate benchmarks, active managers outperformed in only two of the nine categories. Vanguard declared: "During periods of significant dispersion of returns across style boxes, relative results for the active fund universe will be primarily influenced by a manager's exposure to a benchmark (beta) and less influenced by the manager's skill and the fund's costs."

This is why I was surprised at Vanguard's statement that "Index-oriented investors can add the potential for above-market returns by including one or more carefully chosen, low-cost, actively managed funds in their portfolio." Its own evidence says that it's unlikely that will happen.

It was almost 20 years ago now that William Sharpe demonstrated that active management is a loser's game no matter the type of market or the asset class. In his paper "The Arithmetic of Active Management," Sharpe summarized the simple story in the following way: "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

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