Vanguard index funds lose out to its own stock-picking fund

Just ask any Boglehead—meaning a disciple of the late Jack Bogle, the prophet of index funds and founder of index giant Vanguard.

It is a powerful argument and has plenty to commend it.

But an entertaining research paper from economist Edward Tower, professor at Duke University, raises an awkward point. Even though Vanguard is the pioneer of index funds, he points out, the firm’s own mutual funds sometimes disprove the rule.

Vanguard’s Capital Opportunity mutual fund, for example, has been crushing its competing index fund for years, he reports. Vanguard Capital Opportunity picks so-called “midcap growth” stocks, meaning faster-growing stocks typically with a market value between $2 billion and $10 billion.

Over the last 10 years it’s up 226%. 

Vanguard’s low-cost index alternative, the Vanguard midcap Growth ETF : Just 154%. 

Tower argues that this isn’t an outlier, and that when you compare active funds run by Vanguard (and Fidelity) with corresponding index funds, outperformance is the norm. 

“I find diversified domestic active funds beat their indexed counterparts,” he writes. “The same result obtains for Fidelity diversified domestic active funds. An alternative approach finds similar results for Vanguard’s global, international, sector, and specialty funds.” Out of 16 Vanguard active funds, he says, only five did worse than their benchmarks.

There again, it depends on what you are measuring. Tower is looking at so-called risk-adjusted returns, known on Wall Street as “alpha.” (Greek names are popular on Wall Street, where many alphas, betas, gammas and deltas have paid for a nice, brand-new Omega.) As Tower writes, “Following William Sharpe, I regress the monthly return of each Active fund on the monthly returns of Vanguard’s index funds, constraining the sum of the coefficients to one. Consequently, each coefficient represents the portfolio weight of the corresponding index fund in a portfolio that duplicates the pattern of returns, and therefore management style, of the Active fund.”

(William Sharpe is the Nobel laureate economist who is the father of modern portfolio theory.)

This form of outperformance may not show up in the way one expects. For example, by Tower’s methodology Vanguard’s large-cap value fund Equity Income has a “positive” alpha, meaning it has outperformed its index on a risk-adjusted basis. While Vanguard’s own data show that the fund has indeed edged the “Spliced Equity Income” index it uses as a benchmark, the casual observer might note something equally interesting: Over 10 years and five, the fund has produced effectively the identical total return as the low-cost Vanguard Value exchange-traded index fund

It was the great Wall Street writer Fred Schwed—his classic, Where Are The Customers’ Yachts?, remains the best single introduction to the stock market—who explained the perils of chasing market-beating performance. Imagine, wrote Schwed, a great coin-flipping contest. People line up facing one another, and in each pair one flips a coin and the other calls it. The winner stays in the competition, and the loser drops out. Do this over multiple rounds, and you will soon end up with a small group of competitors who have called the coin successfully each time. Eventually you will end up with one person, the winner of the competition, who has called it successively every time.

If this were Wall Street, people would then gather around this amazing genius, seeking his pearls of wisdom about how to beat the coin toss time and again. (These days we’d say the winner would always be on TV, predicting the market’s next move.)

But the reality is that he or she is a product of chance. In this competition someone must end up the winner. Logically, some active funds must beat the indexes just as some must lose, even if it’s random.

But Tower’s research is a smart reminder of a couple of items of investing wisdom that often get overlooked.

First, the magic of index funds doesn’t lie in the indexing, so much as in the low costs. The active Vanguard funds that have done so well generally have very low fees. The Capital Opportunity fund, for example, charges just 0.43% a year for the regular shares, and 0.36% for the “admiral” class shares, which require a $50,000 minimum investment. (The fund is closed to new investors, by the way.) Active management has a much better chance of adding value if you keep down the costs.

Second, there is nothing inherently wrong with stock picking. Some fascinating and often overlooked research some years ago found that where money managers were given a free hand, and were able to invest exclusively in their highest conviction stock picks, their chances of beating the market were much higher. A big reason so many active fund managers end up so mediocre is that their funds are run more by their marketing departments than their investing departments: Most fund companies dare not deviate too much from their indexes, which means you, the outside investor, end up paying high fees for a fund that hugs the index anyway.

You’d think there would be more mutual funds offering high conviction bets for a low fee, wouldn’t you? But Wall Street is a business, and overpriced, aggressively marketed and mediocre mutual funds have generated a lot of revenues for a long time. Which is why index funds have so often made so much sense.