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Active Versus Passive Is the Wrong Question Morningstar Research | John Rekenthaler

index funds. I then calculated the average total- return rank for each group, as compared against other funds of the same category, over the trailing 15 years.

U.S. Diversified Stock Funds 15-Yr Category Ranking, by Total Return

60

70

Recently on Morningstar.com, I asked, do active funds have a future? Several readers found that to be a silly question. There are good funds of each flavor, they argued. Rather than pit active funds against passive funds, I should distinguish between deserving funds and those that are not. I agree. That column discussed what is, not what should be. And what is, is a public-relations thrashing. Index- fund managers have convinced the marketplace that the critical investment issue is whether to be passive or active. The triumph of indexing has become a familiar tale, detailed not only in The Wall Street Journal ’s recent feature on Vanguard but also again days later in Jason Zweig’s column. Active management is regarded as a loser’s game. That belief, however, is incomplete. It’s true that active management sold at its customarily steep price is second-rate. But so are high-cost index funds. How a fund is managed is less important than its cost headwind. To test the proposition, I sorted active U.S. diversified- stock funds into two groups: the very cheap and the expensive. Funds in the first group have current annual expense ratios of no more than 0 . 50% , while those in the second have expense ratios of at least 1 . 50% . Several of the discount funds were offered by Vanguard; I set those aside into a new pool to be measured separately. Finally, I discarded DFA ’s funds. They appear in Morningstar’s database as active funds, because they must be somewhere , but in reality they straddle a middle ground. They do not belong with active funds for the purpose of this test. That made for three comparison groups for active funds: 1 ) Vanguard, 2 ) not from Vanguard but priced like Vanguard, and 3 ) expensive. To those three groups, I added a fourth group of Vanguard

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43 44

50

33

40

30

20

10

Vanguard Active

Other Cheap Active

Vanguard Passive

Expensive Active

Data through July 31, 2014. Source: Morningstar Data.

Vanguard’s actively run funds have outperformed their more-famous index siblings. The very cheap active funds from other companies were somewhat behind Vanguard’s active offerings but were fully competi- tive with the company’s index funds. The costly funds lagged significantly, as expected. The index funds’ average ranking of 44 may strike you as unimpressive. If so, that is partially because you have been oversold by index marketers, who like to imply that actively run funds outgain indexes over the long term as often as metal scavengers find long- forgotten gold hoards. The occasion is not nearly so rare. But there is also a legitimate explanation: Every Vanguard index fund from 15 years ago exists today, where as many losing competitors closed their doors and thus do not appear in this study. Vanguard’s index funds compete against the winners. This includes Vanguard’s active funds, several of which were merged or liquidated during the period. Thus, I hesitate to declare victory in this contest for either Vanguard’s group of active funds or for the larger pool of non-Vanguard funds. While some active fund families rarely if ever kill their babies (for example, American Funds), the practice is prevalent enough such that one must be wary when comparing live funds against live funds. Nonetheless, even