Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

As my Bloomberg News colleagues reported earlier this week, the financial juggernaut known as Vanguard added $185 billion to its low-cost and passively-managed funds so far this year, “which puts it on pace to…" wait for it, wait for it, "...bring in more money in one year than any asset manager in history.”

Vanguard deserves its success. It's brought low-fee, principled investing to the masses in a singular and admirable way.

According to Bloomberg, the average asset-weighted fee of a Vanguard fund is 0.13 percent, compared with 0.66 percent for an active mutual fund. On $185 billion, this translates into fee savings of nearly $1 billion this year alone – a boon to Vanguard's legions of investors.

But as the industry leader, there's much more that Vanguard could and should do.

The company's tremendous popularity is due in large part to the failure of active managers.Every six months, Standard & Poor's publishes its SPIVA U.S. Scorecard, which reports the percentage of actively managed funds that underperformed their benchmarks. The results are rarely pretty. As of June 2015, for example, 80.8 percent of actively managed U.S. large cap funds had underperformed their benchmark over the last five years, and 79.6 percent underperformed over the last ten years.

Failing to Keep Up
Percent of U.S. large cap managers who lag the S&P 500 Index net of fees.
SOURCE: Mid-Year 2015 SPIVA U.S. Scorecard

Do active strategies lack merit or is there something else going on here?

In the four decades since Vanguard launched the first passive, low-cost fund – its flagship S&P 500 Index fund – academic researchers have studied the strategies used by active managers to beat the market, techniques that emphasize screens such as value, size and profitability. Famed active managers from Warren Buffett to Peter Lynch, and countless others, have for decades attempted to cherry pick stocks that are cheaper than the broader market (value), or smaller and more nimble (size), or have superior earnings (profitability).

Research shows that these strategies have worked, and the performance numbers are compelling. Nobel laureate Eugene Fama and Ken French are renowned for their research on this subject. According to their data on U.S. markets, equity returns from value companies have outpaced growth companies by 3.7% annually since 1964; returns from small companies have outpaced large companies by 2.8% annually over the same time period, and returns from more profitable companies have outpaced those from less profitable companies by 2.7% annually over the same period.

Strategic Thinking
Time-tested active strategies have paid off.
SOURCE: Website of Kenneth R. French

This performance can’t be explained by mere chance (in geek speak, the results are "statistically significant"), which implies that it’s reasonable to expect similar results in the future. Not always, but more often than not.

So why are the SPIVA numbers on the performance of active managers so lousy? As Shakespeare might say, it appears that the fault is not in our strategies, but in ourselves.

One culprit is fees. SPIVA’s benchmarks do not reflect fees, and fees for actively managed funds are notoriously high. If fees for active and passive management were the same, the fruit of these proven investment strategies would show up in the numbers.

A second culprit is the manager. Analysis of investing performance assumes that managers are coolly and methodically applying these strategies over time -- which, of course, is not easy to do. Yes, some super humans such as Warren Buffett have been able to do it for decades, but many managers will fall far, far short of the Buffett standard. This too is undoubtedly reflected in the numbers.

That doesn't mean, however, that active strategies are doomed or even second-tier. Fund companies can deploy the same methodology that Fama and French's research has shown to work, and the funds can do so systematically, reliably, and cheaply.

Active Investing Pays
Annual excess returns in U.S. markets from value, size, and profitability strategies since 1964.
SOURCE: Website of Kenneth R. French

Some fund companies have already taken note, and a new generation of actively-managed funds are coming to market. So far, they appear to deliver on the promise of systematic and reliable exposure to value, size, profitability, and other sources of potential outperformance. But with few exceptions, the fees are still too high.

This brings us back to Vanguard, the first firm to deliver passive, low-cost funds to investors. With growing evidence that active management is at least as meritorious as passive management, Vanguard should now offer active funds for the same low cost as its stable of passive offerings.

A move like that would allow investors to more meaningfully diversify their portfolios, not only across asset classes, but also across strategies. It would also allow investors, at long last, to choose among investment strategies based on merit rather than cost.

Vanguard’s S&P 500 Index fund famously charges just 0.05 percent. Now imagine an actively managed U.S. large cap fund for the same low cost. If that came to pass, SPIVA's annual rankings might start to look a whole lot prettier.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net