(PUB) Investing 2016

VANGUARD 10 Things Vanguard Won’t Tell You—Part II

WHAT COULD VANGUARD do better? That’s the question Dan and I asked ourselves a few months back. Last month we discussed four areas where Vanguard could up its game. And as promised, here are six more places we’d like to see Vanguard improve. 5. While Vanguard likes to tout num- bers showing that index funds outper- form active funds, that’s not the case for Vanguard’s active funds, which, like index funds, are low-cost. The argument that index funds will outperform the average actively man- aged fund after fees makes sense. In aggregate, all actively managed funds roughly make up the market, and if their expenses are higher than those for index funds, which also make up the market, well then, the index funds come out ahead. And the numbers back this up. Consider that over the past decade, 500 Index and SmallCap Index out- performed roughly 80% of the funds in their respective peer groups. But at Vanguard, actively managed funds aren’t run at high or even average costs, but at low costs—not quite as low as Vanguard’s index funds, but darned close. The cost advantage that index funds have over active funds is narrow- er within the Vanguard stable. By my count, through the end of 2015, half of Vanguard’s actively managed domestic and foreign stock and balanced funds outperformed in-house index competi- tors over the prior decade (or since inception if the active and passive funds were not around for 10 years). That’s a pretty decent track record relative to the mutual fund industry at large. More importantly, it’s not a bad record considering that it includes the likes of Explorer and U.S. Growth , which I have long said were overmanaged mess- es. Funds that outperformed include all the PRIMECAP Management-led funds, Health Care , Dividend Growth and International Growth —funds Dan and I have recommended for many years

in the Model Portfolios . Not only can active management outperform passive index funds, but it is possible to identify those managers ahead of time. We’ve done it for years. 6. Vanguard says its multimanager format, first adopted in 1987, “can reduce portfolio volatility, provide potential for long-term outperfor- mance and mitigate manager risk.” I’d say they are batting, at best, one out of three. To take just one example, Explorer is the poster child for Vanguard’s failed multimanager efforts, with 15 managers from seven different firms (and that’s after Century Capital was dropped from the fund in January). The chart below plots the rela- tive performance of Explorer versus the Russell 2500 Growth index since Kalmar was added as the sixth sub- adviser a little more than a decade ago. When the line is rising, Explorer is out- performing. You can see pretty clear- ly that for all the manager additions and subtractions, it’s been a persistent downtrend for Explorer. Strike one. Strike two concerns that claim about reducing risk. To give just one example, in the 2008–09 financial credit crisis, Explorer suffered a 52.4% loss over 16 months ending in February 2009, which took 24 months to recover. The Russell 2500 Growth Index suffered a nearly

identical 52.8% loss over the same period (though that doesn’t include a manage- ment fee) and recovered in 22 months. I’d call that a draw in terms of risk. As for the final “benefit” of multi- management, the reduction of “manager risk,” well, that’s kind of obvious, isn’t it? If Vanguard doesn’t hire managers who all invest in the exact same stocks and in the same fashion, and they hire a bunch of them, then ipso facto, you can claim lower manager risk. But what’s the benefit? They haven’t reduced the risk that really matters (drawdown), and they haven’t outperformed. Why is multimanagement a good idea? 7. Vanguard is more concerned with pulling in assets than preserving per- formance. A corollary to the weakness of Vanguard multimanager strategy is the fact that Vanguard would rather add more managers to their most popular active funds and keep them open to pull in assets, rather than close them to pre- serve their outperformance. In fact, if the conglomerations only match their index benchmarks, Vanguard is happy enough. Mae West wasn’t talking about Vanguard when she said, “If a little is great, and a lot is better, then way too much is just about right!” But she could’ve been describing Vanguard’s approach to the multiple manager for- mat. Yes, there can be a benefit to own- ing different managers, particularly if they are hunting in different waters—as Dan and I recommend in the Model Portfolios . But you can easily go over- board when adding managers to a sin- gle portfolio when all are essentially dropping their hooks in the same small area, be it small-cap stocks or large-cap dividend payers. Adding multiple managers to a fund makes the active fund look more and more like the index it’s trying to beat. Another way of thinking of it is that with multiple managers you reduce the chance of a really bad out-

Explorer vs. Russell 2500 Growth Index

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Rising line = Explorer outperforms

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4 • Fund Family Shareholder Association

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