A recent study by Standard & Poor’s Financial Services LLC that has been getting a lot of play in the press over the past couple of weeks purports to show that active management can’t succeed.
But this study and others like it choose expediency over experience. Investors who blindly follow their conclusions will be the poorer for it.
Actively managed mutual funds have come increasingly and repeatedly under fire, as researchers trot out studies showing that, en masse, mutual funds run by human portfolio managers don’t perform as well as the stock market. Those that do outperform, they say, cannot be chosen in advance, because the winners in the performance race are random.
The takeaway from these studies is that investors should simply buy index funds to satisfy their portfolio needs, sit back and let the markets hand them whatever returns they produce.
The studies may be correct on their faces, but they are wrong in their conclusions. First, almost all studies of mutual fund performance base their findings on static time periods, such as the five-year period ending in the most recent quarter, or the six-year period since the start of the current bull market. The presumption is that the investor has invested his or her money at the start of this period and simply stayed the course.
Nothing could be further from reality. Consider the typical investor in a company-sponsored 401(k) retirement account. Contributions taken from bi-weekly paychecks are added to the workers’ accounts regularly for months at a time.
Hence, some of that money may be invested for five years from January through January, but more dollars will be invested over other time periods from, say, February through February, or April through April. To measure performance over one static, artificial time period simply doesn’t reflect the investor experience.
The solution is to look at multiple time periods to accurately measure fund performance that more closely aligns with an investors’ true experience. For instance, over a full decade, there are actually 61 different five-year periods, 85 three-year periods and 109 one-year periods you can measure if you roll forward month by month.
Using “rolling returns” analysis, something Jeff and I do all the time, is just one way to raise your odds of finding active fund managers who have outperformed and will continue to outperform the market or their benchmarks consistently.
In addition, investors can narrow their searches by building portfolios of funds that share the same characteristics as the best index funds — low costs and diversification. One need look no further than the content of this letter and the Vanguard fund family for proof.
Consider, for example, Vanguard’s flagship Vanguard 500 Index Fund (NYSEARCA:VOO), which tracks the S&P 500. At the end of 2014, you might have looked at the fund’s 20.2% three-year annualized return and compared it to the actively run Vanguard Dividend Growth Fund Investor Shares (MUTF:VDIGX), where manager Donald Kilbride had generated a 17.5% annualized return over the same period.
With a higher return for the three years through 2014, you might have concluded VOO was the preferred option to VDIGX. Yet, had the investor compared the two funds one year earlier, he would have drawn the opposite conclusion. Rather than using a static three-year measure, though, a rolling-return calculation shows that since taking charge of Dividend Growth in February 2006, Kilbride’s average three-year return of 8.3% was fully 1.6% better per annum than the index fund’s.
In fact, several active managers running low-cost Vanguard funds have similarly beaten the index benchmark.
The same benefits that accrue to index fund investors, such as low operating costs and low turnover, can be found at funds run by human managers — you just have to look for them. Comparing the performance of every portfolio in the mutual fund universe to a single index over a single period of time is a poor substitute for careful, considered research seeking to find the best flesh-and-blood managers on and off Wall Street.
Investors can choose expediency and simply buy an index fund, but experience shows that spending a little time focusing on one of the most important financial decisions you will ever make to find smart, capable and consistently superior active fund managers could mean the difference of tens of thousands, if not hundreds of thousands of dollars in retirement.
As Vanguard founder Jack Bogle has written, “Seemingly small differences in annual rates of return can result in enormous differences in total return over long periods of time. Do not ignore the magic of compounding.”
Editor Dan Wiener and Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, an award-winning monthly advisory letter that keeps subscribers abreast of recent developments at Vanguard, and provides long-term guidance for investing in the Vanguard fund family.
