How to effectively use actively managed funds

Much has been said about the merits of index funds, or passive investing. But as Vanguard experts Bryan Lewis, Frank Chism, and Matt Piro point out, both active and passive investing can work in a long-term portfolio as long as you maintain your target asset allocation and are willing to stay the course. 

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Jon Cleborne: So when we’re thinking about sort of specific stocks and specific types of stocks, we’ve talked a little bit about active management earlier in the program and the ability of a manager to choose the stocks that are going to outperform. So, Matt, again, this is part of what our team does on a regular basis. So can you talk a little bit about the pluses and minuses of investing in actively managed stocks or stock funds or actively managed mutual funds more generally?

Matt Piro: Yes, absolutely. I mean I think to start, though, I’ll go back to the importance of asset allocation. I think that’s always important to keep in mind that our research would tell you that it is roughly 90% of the pattern of performance that your portfolio ultimately delivers is based on that decision. So this decision of active versus index is much further down the decision tree, if you will. But a couple things that I think about here is, one, I do start with costs. Index funds typically do have a lower expense ratio. They are a lower-cost vehicle. On average across the industry, active funds do tend to be a little bit more expensive. Now that’s not true across the board. For example, at Vanguard we have very low-cost active funds. But you do pay a little bit more for access to active management. And why is that? Well, that’s because of the resources behind that, the team of investment managers and analysts who are trying to pick those stocks that will ultimately outperform. And that’s really what most investors are looking to achieve when they select an active fund. So this is really what you’re going after in most cases is some degree of outperformance, outperformancing in some market or a part of the market. And that’s really, ultimately, what you’re going for. So if you’re going to invest in an active fund, there’s another thing you have to keep in mind and that’s the concept of patience because it is an unreasonable expectation for active managers to outperform year in and year out. There’s just too much evidence that it’s very challenging. So, inevitably, you are going to experience periods of underperformance. So even the most successful funds that we have evaluated, and, Frank, your team in the Investment Strategy Group did some great research on this where we looked at funds over a 15-year period and we isolated funds that we deemed to be successful. And when we looked at the performance over that 15-year period, we actually saw most of those funds experience periods of underperformance in 4, 5, 6 calendar years of that 15-year period. And these are funds that deliver that outperformance, which is what investors were looking for over that long-term period of time. But you need to be willing to stay the course and remain convicted in that particular active strategy. So that’s an important thing to keep in mind. So I think about costs and I think about patience as two of the important components of kind of really understanding if you are comfortable with that tradeoff as you make that decision as an investor.

Frank Chism: And it’s interesting you said, Matt, we also did some work around making the decision in picking active managers. And what we found is you do have these periods of significant underperformance or you have 2, 3, 4 years in a row. And it’s not like picking a restaurant. And so my wife and I whenever we’re anywhere, it’s like, “Where do you want to eat?” You go on Yelp, you go somewhere, and you have 200 people say, “This restaurant’s great.” And it’s probably pretty good. That’s probably a pretty good indicator of where to go eat. Or colleges, right? I have an 18-year old. I looked at colleges last year. And Princeton’s not going to be number 2 for five years and then go to number 200. It’s probably still going to be up there. And the thing with active management is it’s cyclical, right, and managers tend to outperform. The way they pick stocks tends to come in and out of favor and you really have to think about it differently. You can’t just say, “Hey, this guy is doing great for the last 2 or 3 years. I think we’ll go with that.” Or, “This person’s done really poorly for 2 or 3 years, we should get out.” If anything, it may very well be you should take the opposite approach. Not necessarily, but it’s more to it than just I’m going to get an active manager and they’re going to outperform forever. So, yes, excellent the way you laid that out.

Jon Cleborne: So when you think about adding an actively managed fund to a portfolio, how should you think about that? How much actively managed— How much of an allocation do you want to have the actively managed funds versus passive funds or index funds? How do you guys generally counsel folks on that front?

Bryan Lewis: This is what I will talk to clients about, right. Is it more important to never underperform the market or is it a goal of yours to try to outperform? And you go through all the risks of that with clients. And I think it really depends on the different types of accounts that you have whether you have these taxable accounts, as I was alluding to earlier, or IRAs, 401(k)s. Vanguard, we’re very good and I think we’re known for indexing, but we’re very good at actively managing portfolios as well. And I think patience is the key. You don’t want to abandon a fund when it’s down because then you start chasing returns and over time that’s going to be detrimental potentially to the portfolio and meeting your objectives with the portfolio. So talking through the risks. And I think it really depends on the types of accounts that you have. Typically we don’t want to have actively managed funds in a taxable account, to our point earlier about the capital gain distributions. But if you have a preference for that, ideally we’d rather see that in a tax-deferred account first.

Important information

All investing is subject to risk, including the possible loss of the money you invest. 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.

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