Vanguard leaders discuss the considerations for combining active and passive investments

Vanguard is widely known as a pioneer and advocate for indexing, but we have a long-standing commitment to active management as well. In this video, experts from Vanguard’s Investment Strategy Group and Portfolio Review Department explain our fund management philosophy and methodology for both strategies.

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. How does Vanguard do both active and passive management well?

Walter Lenhard: On the passive side, our philosophy is really to offer the best possible products at the lowest possible prices. So we’re always trying to lower the expense ratio of our products. But we also go out there and we find the best benchmarks for every single asset class. And people normally think about indexing—the advantages of indexing—being low cost, diversification, and risk control. But there’s really a second tier of reasons why indexing works so well. And that’s low turnover, low transaction costs, and low capital gains realizations.

Jeff Johnson: On the active side, it really comes down to talent, cost, and patience. It’s so important—critically important—when you’re employing an active strategy to ensure that you have the most talented manager, with the most disciplined investment process that they’ve most consistently applied over time. And, unfortunately, this is becoming more and more competitive. The rewards and the benefits to those investors who are able to outperform over time are immense, which has attracted quite a bit of attention over the years in the form of other humans and [also] computers. So this is an aspect of active management that is becoming only more challenging over time. Investors can improve their odds by ensuring that they’re paying the smallest amount for that access to active management over time. And they also have to recognize that they’re going to need to be patient, because even those managers who have the skill and who might have been able to outperform over time are also going to encounter sometimes extended periods where they underperform.

Brian Wimmer: The one thing that [both Walter and Jeff] mentioned that I think link the two together then, is ultimately cost. So we’re able to get successful strategies at a low cost. I think a lot of times we think . . . intuitively, in other areas of life, [that] if you pay more, you’re going to get higher quality or more performance. But the counterintuitive thing in the investment industry is [that] really if you’re able to decrease your costs—whether it’s active or passive—we’re able to improve the odds of long-term investment success.

Amy Chain: Jeff, what are some key considerations for investors when selecting an active manager?

Jeff Johnson: As we’ve discussed, for most investors most of the time, we really believe that index portfolios can be a great option for them. But for those investors who do have a preference for active management, our conviction in active management is really conditional upon a variety of characteristics being in place. The firm has to be stable and sound, with a diverse client base and a stable asset base over time; the investment team needs to be deep and experienced and stable. We look closely at that investment process and look to ensure that it’s been consistently applied—both in periods where the market has favored [a firm’s] style of investing, but also periods where maybe their style of investing encountered challenges. We believe that if you have the right firm, you have the right investment team, and they’ve employed a consistent process over time, they increase their odds of outperforming.

Brian Wimmer: One of the things that I think’s really interesting about our answer, and that we talk about [with] active management [at] Vanguard, is that it’s not about past performance exclusively. So, Jeff, you talked a lot about the process and about the people, and those are critical considerations. And while we of course would like to see a track record of some type of success, it’s not about that purely—because, as we know, active management can be inconsistent, there can be periods of underperformance. So it’s really important to go beyond just what . . . the last three- or five-year performance [has] been, and understand more about the teams and about the specifics of the active manager that you’re actually purchasing.

Jeff Johnson: And the process can be littered with paradox. Sometimes the best managers who might be most poised to outperform going forward, can be those that have struggled the most relative to a benchmark over the last three or four or five years.

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
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