Jim Nelson: Actively managed funds or passive index funds? It’s a common question that many investors and their advisors confront during portfolio construction. Is it really that simple, or are there other factors to consider?

I’m Jim Nelson, and welcome to Vanguard’s Investment Commentary podcast series. In this month’s episode, which we’re taping on June 20, 2018, we’ll discuss factors to consider when deciding which investments should go into your portfolio.

Joining us is Dan Berkowitz, an investment analyst with Vanguard Investment Strategy Group. Dan, thanks for joining us today.

Dan Berkowitz: Great to be here.

Jim Nelson: Before we dive into the recommendations for portfolio constructions, why don’t we take a step back and just talk about how Vanguard defines active and passive investments.

Dan Berkowitz: That’s a nice place to start the conversation. And when we talk about active and passive, it really is important to clarify exactly what we mean by an active investment and what we mean by a passive investment because many folks in the industry do use these terms slightly differently. And there is no one right way to define them, but it’s, obviously, helpful context for our conversation here today.

And so, from Vanguard’s perspective, we consider passive to be broad-market cap-weighted indexing. And then, so an active investment would be any tilt off of a broad-market cap-weighting scheme.

Jim Nelson: And by tilt you mean what?

Dan Berkowitz: Any investment that uses a weighting scheme or construction that is different than broad-market capitalization.

Jim Nelson: So can you give us an example of something that people might think was a passive, but we would consider more active?

Dan Berkowitz: Yes, it’s a good question, Jim. And, honestly, this used to be an easier discussion for us when market-cap-weighted indexes primarily were what was out there in the indexing universe. But what we’ve increasingly started to see is, these lines blur between active and passive. And a great example of this is the growth, the proliferation, of the fundamental indexing category, or that smart beta category, where now active decisions around fundamental characteristics that you can use to weight securities are being baked directly into index construction and index methodology.

And so, while these may be index funds or ETFs, we would by no means call them a passive option based on the definitions that we were just talking about. And so herein lies the challenge for us in that it’s become increasingly difficult for us to take a look at an investment option as a stand-alone and say, “This is active, or this is passive.” We think that investors just need to do a bit more due diligence, really, and look under the hood.

Jim Nelson: Now, in recent years, we’ve seen many investors moving out of active funds and putting money into index funds. What does our research show?

Dan Berkowitz: Yes, so what we think describes recent trends more accurately, actually, than that active-versus-passive phenomenon that we’ve read about frequently is, actually, high cost versus low cost. And so, more specifically, dollars flowing from higher-cost products to lower-cost products. And we see this trend reflected in industry cash flows.

And interestingly, Jim, if we disaggregate the industry cash flows, for example, in the U.S. equity universe into active and passive categories, we would see the same trend in both pieces. So dollars flowing into lower-cost active products and dollars flowing into lower-cost passive products [are] typically at the expense of higher-cost products in both of those categories.

Jim Nelson: What do you think’s driving that?

Dan Berkowitz: So, regardless of whether we label something active or passive, we think that investors are becoming increasingly discerning when it comes to factoring cost into the investment-selection process. And this is something that we love to see because we know how critical low costs are to achieving investment success.

Jim Nelson: Is it the Vanguard effect? Like we enter a market and prices go down?

Dan Berkowitz: We have seen [that] with the growth of indexing, asset-weighted expense ratios across the board coming down on the active side. We would love to take credit for it, but either way, Jim, it’s a boon for investors, lower costs.

Jim Nelson: Yes, that makes sense. What should investors be looking at when choosing an active fund? Are there things that investors can do to improve the odds of active management success?

Dan Berkowitz: Yes, that’s a great question. And we know that there’s really no easy answer here, because we have a manager search and oversight team here at Vanguard that is constantly evaluating our active lineup. We do know that past return or alpha for a fund manager in particular, it doesn’t tend to be a great predictor of future results, unfortunately. And so our process here is highly qualitative in nature. And, in fact, we like to say that performance should be an outcome of a strong talent-identification process not a driver.

Jim Nelson: Yes, so how would that play out for an investor working with an advisor?

Dan Berkowitz: We focus on characteristics like a manager’s people and investment philosophy and investment process. And so that would be things like the enduring nature of an investment philosophy, so to what extent would an approach work consistently through different market cycles, the depth of an investment team, staff turnover, things of that nature, rather than honing in on performance results exclusively.

Jim Nelson: So focusing too much on results kind of blinds you to the bigger picture that, really, might better inform your investment approach?

Dan Berkowitz: I think that’s a fair way to put it. And regarding how investors can improve their odds of success when using active management, because this is how we like to talk about using active in portfolio construction, we think that there are three key factors that investors can lean on, again, to really improve those odds.

And the first is talent, as we were just talking about. I think investors and advisors should ask themselves, “To what extent do I have the time and ability to select a winning manager across different asset classes and different sub-asset classes through time?” because we know that the answer may not be I can do this across the board consistently in all of the equity universe and all of the fixed income universe.

The second characteristic is cost. And so, can I access these top-tier managers that I found at relatively low cost? Because, as an investor, I keep more of a manager’s excess return, the less I am paying for it.

Jim Nelson: And that’s a factor that’s easy to get that information too.

Dan Berkowitz: That’s exactly right. And so the third and final characteristic, probably an understated characteristic, I’d say, is patience. And so the ability to hang on to active managers or groups of managers over a long-term time horizon. So through those inevitable ups and downs, those potentially severe and lengthy periods of underperformance relative to a benchmark.

And this is, Jim, an area where we see advisors add a lot of value to their relationships with clients through behavioral coaching, because we know that even the most sophisticated of investors have difficulty hanging on to underperforming investments through time. And so the patience piece really is critical to the success story in using active, and talent, cost, and patience are the three key factors that we use.

Jim Nelson: So let’s jump into portfolio construction. When looking to combine active and passive investments, many investors tend to use rules of thumb as a starting point. Can you talk about some of the ones we commonly see?

Dan Berkowitz: You know, Jim, interestingly enough, these heuristics and rules of thumb that you were just referencing that serve us so well in many other aspects of life, they just aren’t the best place to start with active/passive portfolio construction. And even though many of them seem very reasonable at first blush, and they really do, we think they can often lead investors and advisors astray. And so we commonly refer to them as active and passive myths and misconceptions.

Would you like to talk through a few of them?

Jim Nelson: Sure. I’ve heard that actively managed funds tend to outperform in bear markets. Is that true, and can you speak to some of the misconceptions around fund performance?

Dan Berkowitz: Yes, this one has come up increasingly so, given where equity and fixed income valuations are these days. It’s a natural question. And it’s a common assumption that active managers as a group provide a better degree of downside protection in poorly performing market environments, or bear market environments, whether through a greater allocation to cash or through portfolio management skill. And there certainly are strategies in the active and index universe that are designed to provide a degree of downside protection.

But when we look at active managers again as a group, we just don’t see that they provide, at a high level, a degree of downside protection.

Jim Nelson: Could you tell me a little bit more about that?

Dan Berkowitz: Yes, and rather than even just look[ing] at the percentages of managers outperforming their benchmarks, we think that investors should also pay attention to performance persistence. And so that would be active managers that have performed well in one poorly performing market environment, one bear market, how did they perform in a subsequent bear market environment? Did they deliver consistently strong results across these environments?

And when we look at the performance persistence across bear markets, so, for example, how did a manager that performed relatively well during the implosion of the dot-com bubble, how did they perform during the global financial crisis? When we look at the persistence of these managers across bear markets, we don’t see a particularly compelling case there.

Jim Nelson: So it’s kind of like a baseball player. You want someone that’s going to do well during the season but also do well in the playoffs.

Dan Berkowitz: That’s a good way to put it. We would like to see that degree of consistency if possible. And we do think that there are certainly active strategies and there are strategies in the index universe that can provide a degree of downside protection in poorly performing market environments. We just caution investors not to paint broad active with that brush that they should expect this type of downside protection in these poorly performing environments.

Jim Nelson: What about the idea that active will outperform in inefficient markets?

Dan Berkowitz: So this is another common one that we see, and we tend to hear this as a part of that core-satellite portfolio construction approach, which is that I’m going to be more passive in my informationally efficient markets and I will be more active in my informationally inefficient markets.

Jim Nelson: And what does that mean for the average investor?

Dan Berkowitz: So when we talk about informationally efficient or inefficient markets, we’re essentially talking about the extent that publicly available information is incorporated into prices. And, Jim, some of the common informationally inefficient markets we tend to see are small-cap stocks and emerging markets—two areas that we hear relatively frequently.

Jim Nelson: Because they’re covered less by analysts and stuff, I would think.

Dan Berkowitz: That’s exactly right. And we can make that whole list together. But just like we do with bear markets, one thing that we tend to look at is performance persistence within these informationally inefficient markets. So managers that are performing well in one period, are they also delivering consistently strong results in subsequent periods?

And just like with the bear markets example that we talked about, in these informationally inefficient markets, we don’t see strong persistence data as well. And so instead of using these informationally inefficient markets as a default starting point for investors or advisors, we would encourage investors to use and to go more active in areas where they believe that they can select a winning manager.

Jim Nelson: What about the idea that greater active share leads to greater excess returns?

Dan Berkowitz: Another great myth and misconception to address here, and that’s that active share and, in particular, Jim, what we hear is, high active-share managers are going to deliver better performance results. And, by the way, active share, briefly, is a metric designed to measure the difference between a manager’s holdings and the benchmark holdings. So a greater active share would indicate a portfolio composition that is more different from the benchmark.

Jim Nelson: Makes sense.

Dan Berkowitz: And so when we study, for example, the universe of U.S. equity managers and we rank them by active share, we don’t find that greater active-share managers deliver stronger results. What we do find is that they deliver results that are more different from the benchmark. And that’s intuitive given what active share is designed to do. So more different on the upside and more different on the downside.

And so what we think about active share is that it can be a particularly useful metric to include as a part of a broader screen or a fund-evaluation process, but we do caution investors in using this type of metric to exclusively select a manager.

Jim Nelson: So, Dan, when advisors and their clients are going through the process of building a portfolio and combining active and passive funds, what should they be thinking about, and how do they go about striking the right balance?

Dan Berkowitz: So let me first emphasize that we think this process will always be a blend of art and science. And, frankly, this is another area where advisors do add a lot of value in portfolio construction because there is no one easy answer, no one-size-fits-all approach. And helping investors think through these complex portfolio construction decisions really are a big value add.

Jim Nelson: Okay, and are there specific things that advisors can do with their clients?

Dan Berkowitz: Yes, there are four factors that we use to help think through active/passive combinations. And those factors are gross alpha expectations, we’ll start with this first as an intuitive place to begin. It’s certainly difficult to think through return expectations for any investment option. But all else equal, better performance expectations for active managers should naturally lead investors to greater allocations to active relative to passive.

Jim Nelson: Right. So if you think you can do better with active, then put more money toward active.

Dan Berkowitz: Exactly. More conviction in the managers that you’ve selected would, all else equal, lead you to a greater allocation there.

Another variable, the next variable we look at, is cost drag. And so, when combined with our gross alpha expectations, that gives us a net alpha expectation. So that’s the portion of an active manager’s return that we as investors get to keep. Arguably, what we’re most interested in, right?

Jim Nelson: Yes. And the costs, that information is readily available. It’s something people can zero in and screen on pretty easily.

Dan Berkowitz: That is right. And, of course, if we are talking about taxable accounts, allocations to active and taxable accounts, we do want to make sure that we’re considering tax drag to account for any capital gains distributions that are issued during the year. But all else equal here, lower cost drag, and so higher net alpha expectations, less expensive allocations to our active managers, would lead an investor to a greater allocation to active relative to passive.

The third variable that we look at is the level of active risk that’s embedded in these types of options. And there are a few ways that active risk can be measured, but one common way is through a statistic called tracking error. And a good way to think about tracking error is volatility of a manager’s returns relative to his or her benchmark. And so more volatility or more uncertainty, in this case here, should lead an investor to a lower allocation to active relative to passive. And, again, holding all else equal there.

Jim Nelson: So if the manager is all over the map with their performance, that’s a caution sign.

Dan Berkowitz: Exactly right. If the excess returns are all over the map, all else equal, we would expect that investors would be better served with lower allocations to active.

Jim Nelson: And what was that last factor you want to talk about?

Dan Berkowitz: Right, last but not least, we have an investor’s risk tolerance, or active-risk tolerance here because we’re talking about the use of active in portfolio construction. There certainly is no one-size-fits-all approach to measuring active-risk tolerance, just like there is no one-size-fits-all approach to combining active and passive options. But a really good way to think about it is, how in search of long-term outperformance, which is why we’re using active to begin with, the extent that an investor can tolerate those potentially severe and lengthy periods of underperformance relative to a benchmark that we were talking about earlier, the extent that they can tolerate those periods of underperformance is a decent indication of their active-risk tolerance. And so, for us, again, all else equal, investors that had a greater active-risk tolerance, we would allocate more to active relative to passive.

Jim Nelson: That makes sense. And that seems like a good place to end our talk. Dan, thanks for joining us for this Vanguard Investment Commentary podcast and sharing your insights.

Dan Berkowitz: Yes, thank you for having me.

Jim Nelson: To learn more about Vanguard’s thoughts on various financial planning topics, check out our website, and be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.


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