Vanguard leaders discuss the active passive investment mix


Both index and actively managed funds can play significant roles in a portfolio. It’s a question of choosing the best mix for the investor’s goals and tolerance for risk. In this video, experts from Vanguard’s Investment Strategy Group and Portfolio Review Department address how an investor can combine the two approaches successfully.

Notes:
  • Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Diversification does not ensure a profit or protect against a loss.
  • All investing is subject to risk, including possible loss of principal.

TRANSCRIPT 

Vanguard Perspectives® Join Amy Chain and senior thought leaders from Vanguard’s Investment Strategy and Portfolio Review groups to discuss portfolio construction topics that have become top of mind for our investors. Here’s what our experts had to say in today’s episode.

Amy Chain: Hi, I’m Amy Chain at Vanguard. Welcome to today’s program, where we’ll discuss the considerations for combining active and passive investments, a topic that’s top of mind for many investors across the globe. Joining us to address common client questions on the topic, and discuss a framework investors can follow, are members of Vanguard’s global Investment Strategy Group and Portfolio Review Department. Thanks all for being here today. We’ve been hearing a lot about new ways of indexing, like smart beta, fundamental indexing, and active quantitative indexing. Many clients consider both active and passive when building their portfolios. Brian, how can an investor decide the best mix between active and passive for their portfolio?

Brian Wimmer: A challenging question, one we’re doing a lot of research on currently, is, “How do people start to formulate their thought process around this decision between active and passive?” And I guess the first thing I’ll say is that there’s no one-size-fits-all answer for everyone. Different investors can come at this in different ways and arrive at different answers. So when you’re thinking about considerations and trying to develop . . . how to start that discussion, there’s really two investor considerations and two fund considerations that we like to talk about. For investor considerations, we like to think about conviction, or your tolerance or your ability to select an active manager: What is your confidence level in doing that, given that it is a challenging thing to do? And then also, what is your tolerance for active risk? So with active management—we talked about this—we’re taking on a certain level of uncertainty and inconsistency in outperformance, so what is our tolerance for that as an investor? And every investor is going have to answer that differently. And then we think about the fund considerations. It would be the cost: What am I paying to access a strategy that could improve or lessen the odds of success? And then also think about tracking error. [You need] an understanding of what . . . dispersion [is, and to ask yourself,] “How different am I going to be from the benchmark, and what does that mean for the active funds that I’m considering as part of an active/passive portfolio?”

Amy Chain: Jeff, what does it mean when someone says, “A high degree of conviction in a manager”?

Jeff Johnson: It means that through our research, through our due diligence, through our observations of the manager, we’ve formed an opinion and have formed a high level of confidence that they have skill and that they are likely to outperform their benchmark over time. Now that conviction, that confidence only comes with experience. It requires a considerable commitment of time and resources on the part of the investor, both in an absolute sense, so that they can develop that level of confidence, but they also need to be mindful that there are thousands of other investors out there searching for that very scarce alpha that does exist. It’s being highly sought after and it’s highly competed for. In order to develop that confidence conviction at Vanguard over the years, we’ve used a very large team [that] employs a staff where it’s their full-time job to be canvassing the universe for managers domestically and internationally that we believe [have] that skill. And sometimes it can take months or quarters or years of interactions and observation to form that level of confidence by focusing on the firm and the team and the process that they employ.

Walter Lenhard: A lot of investors are asking if they should make this active/passive decision based on the asset class. Some will say that the U.S. large-cap distribution of returns is very tight, that the range of returns between the best managers and the worst managers isn’t that large. And if you think about small-cap or emerging markets, the range of returns is a lot wider. So on one hand, that might be an area where you’d focus on looking for an active manager, because you could significantly outperform by a percent or 2% . . . . I would say, however, [that] Vanguard believes in indexing because of the zero-sum game. So that means that before expenses, half the managers outperform, half the managers underperform. But after expenses, that whole distribution shifts over to the left a little bit. So in aggregate, indexing is going to outperform roughly 60 to 70 percent of active managers in a normal year. And that’s going to be true whether you’re thinking about the U.S. large-cap or small-cap and emerging markets. And actually, some of the expenses in those more narrow areas can actually be larger, and you can shift that whole distribution over by a percent or percent and a half.

Brian Wimmer: Yeah, and this is a really interesting thing: We talk about active and passive management as this idea of dispersion. So if you think about a passive index fund, you tend to have a very tight dispersion of returns that are closely aligned to the benchmark. Whereas [with] active, depending on the category, you start to widen that, sometimes significantly, getting much wider dispersion—and with that comes some uncertainty. So you have the potential to outperform (by fairly large amounts in some cases), but at the same time, with that symmetrical distribution, you have the potential to underperform by significant amounts. So these are some of the uncertainties and the additional consideration that investors need to think about when they’re talking about active versus passive.

Jeff Johnson: And it still comes down to who is implementing the investment decision and which manager we’re selecting based on our expectation of their ability to outperform. We might identify an asset class where we believe that dispersion allows us to outperform using active management, but we still have to select that manager with the right kind of team, the right kind of process, the right kind of patien[ce] and discipline over time that may be able to capture that outperformance. And that’s no small task.

Walter Lenhard: The way I think about it is that indexing provides asset class returns—but it’s almost more of an average asset class return. So every single year, there are going to be some active managers that outperform the index. So a lot of times I’ll reverse it back on the investor and say, “It depends on your ability to select an active manager.” If you’ve got a strong conviction and you’ve identified a manager who’s going to outperform—he’s outperformed historically, you really believe is going to outperform in the next time period—well that would be the opportunity for you to go ahead and make an active bet in that asset class.

Amy Chain: On that note, I’ll say thank you all for joining us today, and I’ll say thank you for watching. More about Vanguard’s perspective on active/passive combinations in a portfolio is available on our website.

Important information Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. All investing is subject to risk, including possible loss of principal.