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Jon Cleborne
Jon Cleborne
Jon Cleborne: Hello, and welcome to tonight’s live webcast on “Maximizing your actively managed fund strategy.” I’m Jon Cleborne. Over the next hour or so, we’ll discuss how to effectively incorporate actively managed funds into your portfolio. So with us tonight to chat about this topic are two of my colleagues, Daniel Wallick of Vanguard’s Investment Strategy Group, and Dan Newhall of Vanguard’s Portfolio Review Department. Daniel’s group is responsible for the research on portfolio construction techniques, while Dan’s group provides oversight of our actively managed funds and fund managers. Thanks for being here, guys.

Daniel Wallick: It’s a pleasure.

Dan Newhall: Thank you, Jon.

Jon Cleborne: So we’ve been seeing lots of interest in this topic. And, as you know, the goal of this webcast is to cover the issues that are most top of mind for you. Many of you have already sent in questions, and we’ll cover a selection of those. You can also continue to submit questions throughout the session. Now before we get started, let’s do some quick housekeeping. Let me point out a couple of widgets at the bottom of your screen. The blue one gives you access to real-time technical help should you encounter any difficulties tonight, the red one is for submitting questions, and the green one on the right gives you access to more Vanguard research on how to think about active management should you want to go any deeper on the topics we cover tonight. Sound good?

Daniel Wallick: Terrific.

Jon Cleborne: Alright. Well, before we dive in, I think it’s important to just clarify when we say active management or actively managed funds, what are we talking about? So here we’re talking about funds whose managers are choosing specific investments with the aim of beating a market-based benchmark. And if they’re managing a stock portfolio, they’re going to seek to build a portfolio of stocks that will outperform a market benchmark like the S&P 500. If we’re discussing bonds, they might be trying to beat the Barclays aggregate benchmark. It’s not easy to do, and tonight we’ll talk about how to improve your odds of success. As we get into the discussion, it’s helpful for us to know just a bit about who’s watching, so I’d like to ask the audience a question. On your screen now, you’ll see our first poll question, which is, “Are you currently invested in actively managed funds? Yes, no, or I’m unsure.” So please respond now, and we’ll share your answers in just a couple of minutes. And before we get into that, why don’t we spend— Our first question was reflected in many, many, many comments that were submitted prior to this webcast, which is, “Why is Vanguard talking about actively managed funds?” So, Dan, maybe I’ll throw that to you.

Dan Newhall
Dan Newhall
Dan Newhall: Yes, I think it’s a great place to start, Jon, and I think it’s a natural question because Vanguard has, of course, been a very vocal proponent of indexing. And in particularly the past ten years, you’ve seen a real acceleration of interest there, and Vanguard’s had a lot of success. But, you know, on the other hand, I think it’s a bit of a misconception that Vanguard and indexing are just synonymous, that Vanguard actually has deep roots in active management. I think for us the common thread is low cost. Mostly we’re passionate about low-cost, high-value investing. Indexing, in a sense, is the purest form of that in that you’re just trying to track your benchmark. You’re going to track your benchmark more closely the lower your expense ratio is. But we do believe in active management. We have, I think, an incredible array of actively managed funds. So I said deep roots in active management that go back to the founding establishment of the Vanguard Wellington™ fund in 1929. And, in fact, for many years in our 40-year existence, we were primarily an active fund shop. Today we have about a third of our assets or almost a trillion in actively managed strategies across equity, balanced, and fixed income, really making us one of the largest actively managed fund companies in the world.

Daniel Wallick: Yes, Jon, I’ve always thought that that’s the best-kept secret in all of investment management, that Vanguard has a trillion dollars of actively managed money.

Jon Cleborne: Alright, well, so maybe not so strange that we’re talking about active management after all. Alright, well, we got our poll results back in, so let’s take a look at this. Alright, so are we currently invested in actively managed mutual funds? So 71% of the audience is, about 20% is not, and about 10’s unsure. So I think we’ve got a lot of folks who understand active management or are interested in it. So let’s take another poll question here, and our second poll question tonight is, “What percentage of your portfolio is comprised of actively managed mutual funds: 75 to 100%, 50 to 75%, 25 to 50%, or less than 25%?” So if you can just take a couple minutes and respond, we’ll get back to your answers in a second. So, Dan, maybe building off of what we just talked a little bit about, and maybe I’ll flip this to you, Daniel, Greg in Cincinnati asked coming into this, “So how can a Vanguard investor reconcile incorporating actively managed funds into the broader Vanguard passive index fund investing philosophy?”

Daniel Wallick
Daniel Wallick
Daniel Wallick: Right, I think it’s a great question. We get that quite often, and I think Dan had a good answer to that. Another way to think about it would be Vanguard’s investment philosophy is comprised of four elements: Know your goals, have a balanced portfolio, access that at low cost, and be disciplined about your strategy. So stick with the plan. Again, that’s goal, balance, cost, and discipline. What’s interesting is indexing is not a part of that. Cost is, and Dan alluded to this earlier. We think that low cost is really a key success factor. And to the extent that we can deliver active management at low cost, it’s an option as well.

Jon Cleborne: Alright, I think that makes a lot of sense, and that’s going to be some themes we’re going to come back to throughout the course of the conversation here. I think we’ve got our poll results back. So we knew that a lot of people are invested in an actively managed fund, but when we come back to look at the percentage of portfolios, looks like about 25% of folks have less than 25% of that portfolio invested in active management and about another 20% are somewhere between 25 and 50%. So when people are investing in active, it doesn’t look like they’re investing completely in active management. They’ve got a part of their portfolio in active management. And so when we think about that, so you’re combining both active and index investments together, maybe, Daniel, if you can build on what we were just talking about. Can you talk a little bit about some of the advantages and the disadvantages of using both active and passive?

Daniel Wallick: Sure. And what’s interesting about that poll question is I think my experience with talking to clients, all different types of Vanguard clients, is often it’s a mix of the two that people have. And so the advantage of an index fund, and again when we talk about index funds, what we mean is market-cap-weighted index funds. So an index that represents the entire market or the entire portion of that market. That term “index” has become many different things lately, but just to clarify, we mean a market-cap-weighted index fund. Now the advantage of that is you’re getting the market. You’re getting the weighted average of what everybody thinks the accurate price should be, so it’s the clearing price. So there’s some benefit of that. And to the extent, again, as Dan had mentioned earlier, the extent that you can access that at a very, very low cost, that’s the benefit of indexing. The benefit of active is you get that same market plus or minus the performance of the active manager. So that can be an additional amount or that can be a subtraction from that manager. But that modest amount of outperformance, if they’re able to deliver that, when that’s compounded upon itself over the years, can be a really significant difference. And that’s why people are potentially attracted to active management because a little bit of compounding goes a long way for increasing wealth.

Jon Cleborne: So we do have a live question that’s come in, and it’s along these same lines. So Greg asks, “If index funds are outperforming 80% of actively managed funds, why would anybody want to own an actively managed fund?” I think that’s a reasonable question to ask in this space. It is really hard to do this well. So maybe, Dan, I’ll throw it to you on that one.

Dan Newhall: Well, and it’s true that the majority of active funds, actively managed funds underperform net of their expense ratio. So we’ve talked a lot already about the importance of having a lower hurdle to success. And so the lower the cost, you’re shifting the odds a little bit better. I mean the market is a zero sum game. Without any costs, 50% of investors will outperform. In a given period of time, 50% will underperform. Net of cost, it’s close to those statistics that the majority will underperform. So it’s rational to say, “Well, why would you do it?” You know, in my mind, the why is that there is some percentage of fund managers who can outperform. And to the extent you outperform, there can be a material benefit. And you can outperform, in our estimation, by having lower cost, being incredibly careful about who you hand your money to, to run it on an actively managed basis, and being incredibly patient with the results of that. So we think that, yes, the odds are against the average investor; the odds are against the average fund manager of success. You could say, “Alright, let’s keep it simple. Just index it for that reason.” I think that’s very persuasive, actually, in many cases. But if you had an appetite to try to do better and/or you perceive additional benefits of active management in terms of risk control perhaps or additional diversification, you know, if you’re careful about the type of fund you invest in, contain the costs, partner with a world class manager—and that’s what I spend my life helping Vanguard investors do is picking among the world’s best managers—you can have great results. And Vanguard has managed to do it. There’s no guarantee of it. It’s not every year. It can be challenging. It requires patience. But that’s, you know, what we think we’re doing on behalf of investors is trying to tilt those odds back in their favor.

Daniel Wallick: You know, Jon, I have a chart that might actually help this, right? Dan spends his day finding great managers. I spend my life making charts and writing papers. So if we could pull up the zero sum chart, that might be a good visualization of what we’re talking about. And the point about this chart, and Dan was alluding to this, is that what the zero sum chart suggests, right, is that the market cap is the weighted performance of everybody involved, and half the assets are going to outperform and half the assets are going to underperform.

Jon Cleborne: That’s the nature of the average. If the benchmark and the index product is the average, it’s going to be right in the middle of that distribution.

Daniel Wallick: Correct. And what that chart suggests is, you know, if you’re high on that chart, that means there’s more dollars and securities in that one point. But the key point of clarification here: Sometimes we talk about outperformance and we count the number of funds that do that. This chart is suggesting, on an asset-weighted basis, if you dollar-weight the performance, the theory would suggest you’re going to get 50% outperformance and 50% underperformance. And the other thing that’s going to impact that is cost, as we talked about before. Cost is going to move that center line left or right, depending on how expensive everything is. So the two things that really matter, thinking about it on an asset-weighted basis? On an asset-weighted basis, the probability of performance is actually closer to 50/50 than on a count basis. So rather than identifying each fund as an individual choice, if you weight the funds, that’s different. And then cost is going to be a really big impact on that.

Jon Cleborne: So let’s pick up on cost because that’s another question that came in is, “How do Vanguard’s actively managed funds compare to others in the industry?” Maybe, Dan, if you want to talk a little bit about that. We talked about how that’s such a critical component of success, and we know that Vanguard’s known for low cost, but what does that actually mean?

Dan Newhall: Yes. Well, to translate that, you know, Vanguard’s average actively managed fund is at a substantial discount to the industry average.* So that’s a big part. And then how do we do that, I think, is the part I’m very involved in. You know, there’s a couple things. One is, of course, Vanguard is an at-cost mutual fund company, so we keep our costs down. There’s no profit margin on top of that. As these funds grow and become successful, we’re able to pass on economies of scale to investors. And that’s true for the index funds. You know, we tell that story all the time, but it’s also true for our actively managed funds. And then, number two, to the extent that for many, at least, of our actively managed funds, we’ve outsourced it to world-class managers that we’ve been able to identify. What we do for our investors is, investors provide their capital to the fund. That gives us a substantial amount of capital to go out and attract world-class managers who want to run that money. They, of course, want to do well by running that money. We can use our scale to really negotiate an institutional better class fee that we’re the largest buyer of investment management services in the world. And we’re going to negotiate on an arm’s length, independent basis with that manager who, left to their own devices, are prone to charge a higher fee. But with our independent negotiating bargaining power and skills and the fact that they value the partnership with Vanguard and the association, we’re able to negotiate, I think, a win/win for our investors and with the manager that’s attractive to them but in basis points, which is how you measure fees in mutual funds. I think it’s still a very good deal. You know, I might add, too, that when we hire a manager, we think they’re capable of outperforming the market that the fund’s trying to outperform. We think they’re capable of doing that on a gross-of-fees basis over a given period of time, a longer period of time. If we gave that away in a high fee, well, then the net return wouldn’t be so attractive to our investors. So we’ve passed up, we’ve found great managers in the past that we’ve gone our separate ways with because we couldn’t get it to a fee that we felt was a fair split of the excess returns. So that’s really important, and we’re able to do that, again, with our scale and reputation and our arms-length independent negotiating with these advisors.

Daniel Wallick: Jon, maybe I could put a specific number on everything that Dan has said. So the way that comes out specifically is the average fee for our active managers is 0.37%. To put that in context for everybody, that’s cheaper than 99% of our competitors on the active management side and, perhaps surprisingly for many, 70% of the indexes that are offered in the marketplace.**

Jon Cleborne: No kidding!

Daniel Wallick: Yes. So it’s incredibly low-cost relative to the other products that are available.

Jon Cleborne: Yes, I think that’s probably an underappreciated fact. There’s actually, if you look at the resource widget at the bottom of your screen, there is a little bit more information about this. There’s a paper that’s called “You get what you don’t pay for,” and it actually goes into this topic in a good bit more detail. So if there’s interest in that, it’s a really great resource, and it really does get into the details here. So, Dan, I want to maybe come back to something that you had talked a little bit about. You talked about how we get out and how we partner with various different world-class firms. You know, I think when you think about active management, what you generally tend to think about is the Warren Buffetts or the Bill Grosses or the Peter Lynches of the world that are the star portfolio manager. When you think about Vanguard, you don’t hear that as much. So I just wonder, if you can talk a little bit about, your team’s out there evaluating thousands of managers a year that could potentially manage money for Vanguard. How do you guys think about that? How do you think about looking for big personalities and successful track records versus firms that never had a really good track record?

Dan Newhall: Yes, Jon, it’s really interesting. Some of the names you mentioned are very notable success stories. And we at Vanguard have quite a number of really notable success stories. Jim Barrow on the Windsor™ II fund, he’s been managing it for 30 years, PRIMECAP and the founders there. Howard Schow, legendary and incredibly successful investors on Vanguard’s behalf. However, I don’t think we subscribe to the star-manager model. What we subscribe to are what I call the four Ps. When we go out and try to secure the services of a world-class manager, we focus all of our attention on the firm. Is that the kind of firm, kind of environment where the people— That would be the other firm, people. And it’s all about the people. I like to say that it’s like real estate. It’s location, location, location. With active management, it’s about people, people, people. But it’s not about necessarily the star manager. It’s about, yes, the portfolio managers they may be named leader, they may get some of the attention. It’s also very much so about the supporting cast. And I think our best investment management partners have terrific teams of analysts behind the scenes. I mean, Wellington Management Company is one of our most valuable partners. They have over 50 global industry analysts, and they’ve been growing that through time, and they’ve been hiring talent from around the world. And they have talent in London and Tokyo and Singapore and Boston and Radnor nearby. And the amount of talent and resources they put into it, yes, there is the named manager at the end of the day who gets a lot of the credit. And some of these named managers are star managers. Jean Hynes of Vanguard Health Care fund. But they wouldn’t do that by themselves. And so we’re very interested in the whole of the firm and where they work and the named PMs and the resources and their philosophy and their process, and it’s all of those things—firm, people, philosophy, process—that we spend a lot of time on. There’s a lot of detail within that, that we think, ultimately, are the drivers of long-term investment success in active management.

Jon Cleborne: Well, and Vanguard’s had a fair amount of success. I mean, Daniel, we were talking about this beforehand. I think you got some charts that speak to this, we actually did get a question about. So Paramoid asks, “What percentage of Vanguard’s actively managed funds outperform the market over 10 and 20 years?” So I know you’ve got some research that’s looked at that.

Daniel Wallick: Right. So we have a chart that talks about performance in general. It doesn’t necessarily have that specific response to it, but we can certainly speak to that. So if we can pull up the return chart that can articulate this. So there’s a lot of information on this page, but let me try and explain that for everybody. So on the left-hand side, that bar is Vanguard active performance for the time period that’s on the chart, the middle bar is other active mutual fund providers, and the right-hand bar is index funds. And so you can see there’s a median point, right, there’s a middle point of what the broad experience on those funds would have been, and then there’s a top and a bottom. That’s the full range of what your experience would have been if you had picked those funds. And a couple points are important about this chart. One is if you look at indexing first, right, so it slightly underperforms the benchmark, which is what it’s supposed to do because it’s the benchmark minus a little bit of fee that it takes to deliver that and the distribution of results. Right, the range of results is very, very close. So you sort of know what you’re getting with the index fund. On the active side, you can see that the median expense ratio for Vanguard is positive. So it’s over 1% for this time period. Again, very time-period dependent. And for the average or non-Vanguard active, it’s actually a negative number. But then there’s a range of results around that. And that’s really the key question around active management, right? It’s are you willing to live with that potential variability of results for the possibility of outperformance? And that’s really a result. Dan, I don’t know if you have a sense of the percentage of funds outperforming over the last 10 or 20 years?

Dan Newhall: Well, it’s been so—

Daniel Wallick: On a count basis.

Dan Newhall: Well, it depends how you want to count it; but when I think about today Vanguard’s 35 active equity and balanced funds—that would include Vanguard Wellington and Vanguard Wellesley—over time the vast majority of those 35 funds have outperformed their average peer. And two-thirds or so have outperformed their respective indexes, so each fund has its own target index that it’s trying to outperform, and about two-thirds.*** And then so I think if you bought that entire portfolio, you know, and this would be a debate, as well, which one would you pick, I mean, arguably you could buy the portfolio of Vanguard active funds, and you’d do well, and then you wouldn’t have to get into the issue of well, which one. Because, yes, in any given period, as you said, there’s a range of outcomes. And in any year there will be a fund that looks really good usually and then some funds that don’t look very good. We’re looking at that picture right now of Vanguard funds. But over time, and our goal is that over 10 or 20 or 30 years, ideally, there’s a benefit, a material benefit that our investors enjoy. And there’s some truly notable funds, if you think about a Vanguard PRIMECAP Fund or a Vanguard Wellington Fund or a Vanguard Health Care Fund, that have added a tremendous amount of value to our investors. There are a few, on the other hand, that have been somewhat disappointments. But even those disappointments, one of the nice things I think about our model is, we’re still trying to get it right, and we’ll make adjustments. And our average investor doesn’t actually have to move funds if we have a process, an ongoing, oversight process and a discipline with every fund and manager of review. And if a fund actually isn’t firing on all cylinders, if you will, we’ll make adjustments or make changes to the management team to ideally set it on the right course.

Jon Cleborne: We did actually get a question about that specifically that came in. And the question was from Michael in Santa Fe and he asks, “How nervous should I be if my actively managed fund is changing its manager? What should that mean to me, and what should that mean to my holding period and how I think about that fund as part of my portfolio?”

Dan Newhall: Yes, Jon, again, one of the benefits of indexing is you really don’t have to worry so much about who your portfolio manager is. I mean, at Vanguard it’s a whole team and a whole system, and you’re going to track the index. But so with active management, it can be a material concern, and we spend a lot of time thinking about issues as relates to, for instance, succession. So we have some, we talked earlier about some legendary portfolio managers. I mean, eventually, they’re going to retire. So we at Vanguard do spend a lot of time when we’re anticipating the retirement of a manager. I mean, as a for instance, Ed Owens who ran the Vanguard Health Care fund, who’s probably the most successful investor arguably ever for the duration of his running the Vanguard Health Care fund, we had five-plus years of planning for that day. I think our investors should be tuned into that and should sort of care who the portfolio manager is. And if there was an unexpected departure, we at Vanguard would swarm that to try to understand are we comfortable with this sudden successor? And our investors should pay attention to that too because, yes, you know, if it’s one manager and team that created the record, and if that manager or team is a different team, the odds of replicating that record decrease. So it’s probably the most important thing. It gets back to people, people, people, and it’s what we pay more attention to than anything else in terms of how are we going to recreate that success going forward.

Daniel Wallick: If I could, Jon.

Jon Cleborne: Sure.

Daniel Wallick: I think one of the ways that Vanguard is structured also helps answer this question, and Dan had alluded to it earlier. So Vanguard is the world’s third-largest user of active management. And a lot of the active management we use on the equity side is subadvisors. So we hire a manager to run the fund. They’re not an employee of Vanguard, right, they’re a contractor to Vanguard. And what Dan’s team does is spend time looking at those managers and being concerned about the exact question that was asked of what happens when somebody moves? Well, that’s what Dan and his team do all the time. So you can try and do that yourself as an investor or you can utilize the skills and talents of Dan’s broad team worldwide to try and do that as well. And so that’s, hopefully, one of the benefits that the Portfolio Review Department, where Dan works, is delivering to our shareholders.

Jon Cleborne: Yes, I think that makes a lot of sense. So we did get a question from Wendy who asks, “Can I be successful doing this on my own, managing my own funds?” And I think a lot of this it’s complex, and it is challenging. And so, Wendy, one thing that I would make sure that you take a look at is if you look, again, at the resource widget, you’ll see that there is a link to Vanguard’s Personal Advisor Services. And so if you find that this is a bit overwhelming or there’s a lot of considerations here and it becomes more than you want to take on yourself, there are Vanguard advisors who are more than happy, ready, and willing to step in and help. There are a lot of folks that do sort of find this to be fun, and they get a kick out of trying to do this type of research, and they really do enjoy digging in and rolling up their sleeves. And one of the questions we do get asked frequently on that front is, “Gosh, if I’m thinking about active management, I’m thinking about all the places where I could do active management, are there certain parts of the market that I should invest in active? Should I invest in active when I’m thinking about international stocks or if I’m thinking about fixed income or bonds? Is that a better place? Are those markets less quote/unquote, ‘efficient’? Is it easier to outperform in certain places?” Daniel, I know you’ve spent some time on this.

Daniel Wallick: I’ve spent a lot of time thinking about this. So, you know, we had shown that zero sum chart before, right. And if we go back to that chart, the theory behind this, and, again, Bill Sharpe won a Nobel Prize for this. It’s a great way to win a Nobel Prize. But he’s basically suggesting that any time you have a market-cap-weighted index, there’s an equal number of assets outperforming and underperforming. So by that theory, there’s no more inefficient or less-efficient parts of the market, ultimately, to do that. And that comes back to, when we think about what it takes to be successful with active, we think three things need to exist. And this is true for every part of the market. That number one, you have to be able to identify talented managers. And, again, that’s what Dan and his team does. You have to be able to marry that with low cost, which is a bit of a paradox. How do you get a great manager to work at a low cost? But Dan spent some time articulating that. We could spend more time on that if people care. And then, third, right, so those two things, PRD and hopefully Vanguard’s delivering. The third element is we, as investors, have to be patient with active management because no manager is going to give you outperformance every day or every week or every month. We know there’s going to be some inconsistency with that through time. And the only way to potentially capture the benefit is to be able to hold that manager for a long period of time. And those three things together—talent, cost, and patience—is what can lead to success with active management, whether you do that on your own or with an advisor or however you do that.

Jon Cleborne: Sure, sure.

Dan Newhall: And I agree with that, Jon. And I think from our own experience, we’ve had successes and failures in all sorts of— Whether it’s, you know, a lot of people say, “Well, large-cap U.S. stocks, that’s the most efficient market. Just index that. Don’t bother with active management.” Well, I’d say some of our most successful fund managers through time have been in large-cap U.S. stocks. And it used to be, “Oh, yes, small caps. That’s easy. Go actively manage there.” Well, you know what, that can be really tough. And, in fact, that’s where a lot of the hedge funds are, and there’s been a lot of interest in that area. And so I would say to you from experience that small-cap doesn’t appear any easier than large-cap to me. Now on the other hand, the only thing I think there is merit to the argument that the broader the universe, and in other words, a really skilled portfolio manager who’s given the entire globe to invest in arguably has more opportunity to outperform. He also has more ways it could go wrong, but I think there’s some evidence to suggest the broader the universe and the more skilled the manager that that opportunity can give you a good chance to outperform. But it’s certainly not a rule. And like I said, our own experience is some of our best results have come from sort of narrow universes of just large-cap growth or large-cap value. So we do think, as you said, the key thing is just having truly talented managers at a fair price. And one of the challenges investors, I think, run up against when they go outside say large-cap U.S. for active investing is higher costs.

Daniel Wallick: Yes.

Dan Newhall: So some people say, “Oh, of course, emerging markets, I’d actively manage that.” Well that’s where the costs are highest. So large-cap U.S. is actually where the costs are, in our case, the lowest. So that’s an offset to this argument of, ooh, less-efficient markets, which we don’t really subscribe to.

Daniel Wallick: You know, that just underscores another thing that we’ve mentioned that I just think is worth underscoring again. So you can talk about active management in general and then you can talk about Vanguard active management. Again, we mentioned the cost difference before, but it’s really significant, the Vanguard cost difference. So the Vanguard experience of active management is quite different than if you take sort of the entire universe of active management.

Jon Cleborne: So maybe, to go back to something that, Dan, you were alluding to a few minutes ago. You talked a little bit about trying to identify managers with skill. And I think this is one of the perennial challenges with this is how do you find people that are truly skilled at this versus they just got lucky for some period of time? And your team is out there working on this day in and day out. How do you guys figure out who has real skill versus who just happened to get lucky? They got dealt a hot hand, and it shows in their performance numbers.

Dan Newhall: Well, it’s really important, Jon, because of course, history has shown us that there are managers who have hot streaks and managers who might just be lucky. And through that lucky hot streak attract a lot of assets. And, unfortunately, if they’re not truly skilled, they can really disappoint people in the ensuing three years. So there’s a lot of history. And I think one of the arguments for indexing is behavioral to keep investors from chasing a streaky, lucky manager. So there’s not an easy answer to that, Jon, but it’s what we put a lot of energy into is trying to discern, if you will, whether what we see with a manager’s record is just a lucky streak. I mean, you could flip coins. You had 100 people in a room and start flipping coins. There’ll be one person who flips heads enough times. Was he the genius or was it just that they were flipping heads? Statistically someone’s going to look like the genius. So we spend a lot of time trying to discern whether the person who appears to be the genius on the back of their performance really is. And, in fact, we’re very skeptical. In fact, some of the most fertile ground for us for hiring managers is a manager who’s underperformed for the past three years because there’s a reversion of the mean oftentimes if they are skilled. So we spend a lot of time thinking about that, analyzing it, and the longer period of time you have, the better. But it does get back to our primary framework, which is this four Ps, this firm, people, philosophy, process. We think that’s the driver. We don’t spend time picking managers based on performance. We think if you have really high-quality drivers of a world-class firm, great people, I mean I’m talking brilliant people, disciplined processes that are followed faithfully—and we monitor that incredibly closely—with a philosophy that just makes sense to us and our investors and is clearly articulated, you focus on that and ignore the noise, ignore, certainly ignore one-year performance, I’ll tell you this, I’ll add this, the most skilled managers outperform sort of 53% of the time. So in a given year that is pretty much a coin flip. Like in terms of discerning, oh, he outperformed/underperformed, it’s only after sort of a minimum of three years, more likely five years and longer, that you can kind of begin to conclude through some market cycles that, hmm, this guy is actually pretty— This team, this firm, this philosophy process, this is more enduring and I think has a good chance of repeating itself.

Daniel Wallick: Jon, if I could. So, you know, we talked about the way to be successful with active management is talent, cost, and patience. If you look at the patience that Vanguard exhibits with its managers, the median experience, the median tenure of our subadvised managers is 13 years. And if you just excluded the people that Dan has recently hired, it’s 17 years. So we are very patient with the managers because it’s very hard to judge over a short period of time is it luck or skill. It really takes a longer time period with that. And, again, it goes back to if you’re going to use active management, you’ve got to be committed to being able to stick with it. It goes back to that discipline element.

Dan Newhall: Yes, I really believe, I’m the first person to sell index funds because if you’re not willing to commit to it and be patient, you should probably just index. Because we’ve seen this time and again of investors chasing a three-year hot performance. And so we really try to fight that behavioral bias. And like I said, we’ll pick from the managers who have been underperforming. We’re more likely to get them at a fair fee too when they’ve been underperforming. But we want to be really patient. And almost to a fault. We’ve even talked about this with Vanguard senior management and our board of directors that the mistake that we are very willing to make is the mistake of overstaying, if you will, with a manager who we think probably can turn it around. Sometimes we’re wrong about that, certainly, but I think our own experience through 40 years is that more often than not, we’re going to benefit from patience, and we’re really going to hurt ourselves and our investors by being impatient with a skilled manager.

Daniel Wallick: Yes. Yes.

Jon Cleborne: So we do have a live question that came in, and it’s a good reminder for me and, I think, for the three of us because you can slip into jargon-y terminology from time to time. So the question is, “Please define market cap.” So, and, Daniel, you were talking about sort of market-cap-weighted index. What do we mean when we say that? We talked about large cap and small cap; what does that actually mean?

Daniel Wallick: So what market cap means is that you’re taking all of the securities available in whatever market you’re talking about and weighting them by the number that exists. Weighting them by the dollars. So you’re not just taking one security from each company. You’re weighting all of those stocks by how much they actually issue. So it’s the cumulative effect of everything that’s available. There are other ways to index. With the term “index,” we talked about this a little bit earlier. The term “index” means a lot of different things now. Some people have equal-weighted indexes, some people have a fundamental-weighted index. What that means is they’re using a rule other than market cap, which is everything. Just taking everything at its collective weight. And the reason we use market cap is we view that, and others do too, right, as the collective wisdom of every participant in the market of what the appropriate clearing price would be. So it’s the weighted average of the entire opportunity set in either the U.S., say the U.S. market. So the U.S. market cap is all the securities available in the U.S. and weighted by the volume that they issue.

Jon Cleborne: And when we are talking about large cap, we’re talking about generally larger companies that would be in the S&P 500, so your Apples, ExxonMobil.

Daniel Wallick: Googles, Apples, exactly. Yes. And you’ve all heard about—

Jon Cleborne: The companies with small cap you’re talking about much smaller companies oftentimes more emerging companies, companies that have more recently come into being.

Dan Newhall: Right.

Daniel Wallick: And if you look at the U.S. market, it’s typically about 70% large-cap funds make up 70% of the dollars in large-cap funds, 20% are in mid-cap, and 10% are in small. So most of the dollars are in the big companies—the IBMs, the Apples, the Googles that we’ve all talked about.

Jon Cleborne: So we talked a little bit about sort of places where you might invest and, jeez, is active management going to be more likely to be successful in an emerging market or in large-cap. One of the other questions that came in was more about sort of time-period dependence and thinking about the market environment. And the question is, “Can an actively managed mutual fund strategy be more appropriate in either a more-volatile market or potentially in either a bear market or bull market?” So I’d be interested in your guys’ perspectives. Is there a certain time that’s a good time for active management?

Daniel Wallick: So we don’t see that there’s one time versus another, the same way I think we were talking earlier about one part of the market versus another. Because, again, coming back to our recipe for success is talent, cost, and patience. And that talent can exist anywhere, any time. And, again, it’s a very qualitative assessment that you have to make for that. So we really don’t see that there’s a particular time in the market or not. I will say there are times in the market when there’s more volatility, and it’s more unsettling for investors, for all of us, and that can be a more challenging time. But that doesn’t necessarily mean it’s a better time for active versus passive.

Dan Newhall: Dan, I agree with that. But, Jon, I mean, there is a broad range of different active strategies. And so even within Vanguard, we have funds that are actually more aggressive that if you have a poor market environment, are probably more likely to underperform and then we have some more conservative and actively managed funds. But the same thing can be said about index funds. We have a range of index fund styles, if you will, that there are different styles that can perhaps offer some more defensiveness in certain markets and some more aggressiveness in bull markets. And there are some managers who provide some downside protection sort of inherently with their strategy because they might focus on more defensive types of companies, more Steady Eddie companies that pay income. We’ve seen a lot of that. In fact, a lot of the interest we’ve seen in some of our funds, including Vanguard Dividend Growth Fund or Vanguard Equity Income Fund is because they have been a little more defensive. Now you could have had that within sort of comparable index funds too that are pursuing similar sort of defensive strategies. So I agree with your basic point. That’s really not a reason to go index or active. But there are a lot of different ways you can approach the investment problem.

Daniel Wallick: I do get somewhat concerned, right, because we get concerned when we think about are we trying to time the market and pick the manager for the certain circumstances? Because we don’t—

Dan Newhall: That’s challenging.

Daniel Wallick: Yes, we don’t think we know what the future is going to be. So, again, that goes back to that investment philosophy issue of discipline. You have to have a strategy, stick with it. And it’s very challenging to do in this day and age with too much information, information overload, instantaneous access to all sorts of things. So that can be very, very difficult, but we want to be careful about trying to sort of time the opportunity within active management.

Jon Cleborne: Well, so let’s talk about that for just a second because there’s a question that came in about market timing specifically. And there are some actively managed funds that actually are trying to move their asset allocation to take advantage of, jeez, it’s a good time to be in stocks or it’s a good time to be in bonds. That’s a little different than, I think, a lot of the active management that you’d see from Vanguard where we’re oftentimes focused on picking certain stocks that we think are going to outperform other stocks. So I wonder if you can just compare and contrast sort of an actively managed fund that’s changing its allocation versus an actively managed fund that’s focused more on stock selection.

Daniel Wallick: Sure. So those timing funds are often called tactical asset allocation funds. And what they’re trying to do is use signals to move say between stocks and bonds, or could be a variety of other things, based on what their models would suggest is an opportune time to buy. We’ve done some research on that and looked at the track record of those, and we just don’t see those being successful over the long term. That’s just true with timing. We think timing is really, really hard to do. And those funds that try to do that, we haven’t found particular success. And, again, the managers that Dan hires and the board hires and the senior staff hires really are more fundamental, stock-picking, long-term managers and not using that timing element in that very explicit overt way.

Dan Newhall: Yes, I agree, Daniel. Our managers are really not making big sort of market calls. Now I would say on the other hand that generally from a bottom-up stock selection standpoint, they are looking to move to sectors, companies when they think that there’s a more favorable—

Daniel Wallick: Best opportunity, right?

Dan Newhall: —opportunity. You know, that there’s a good company at a nice price or there’s a very high-growth company that people are underestimating. I mean, it is what we pay active managers to do, to sort of pick up portfolio stocks that leads to even sector overweights and underweights. And so we have some tolerance for that. Well, what we generally don’t see or subscribe to is someone who’s making the market call. It’s more bottom up building a portfolio that then from a top-down standpoint there is a little bit of looking at that from a portfolio manager’s perspective and saying, “Does that make sense if I’m overweight financials or overweight healthcare or underweight this, that that makes sense to me given the prospects for the companies that I’ve put in the portfolio?” Similarly, I mean, we do have actively managed balanced funds. You know, Vanguard Wellington Fund I referenced before, where it’s a fairly targeted allocation of 65% stocks and 35% bonds, but the managers, Edward Bousa and John Keogh, who have the equity and fixed income sides, they talk to one another. And when markets are really falling or there’s an opportunity, they’ll move it a little bit. They’ll be a little bit opportunistic is what I’m saying. They’re not making big market calls, but when they see value in bonds or value in stocks, they’ll move a little bit of money here and there and that, over time for the most part, it’s just about disciplined rebalancing. But over time that can add some value.

Jon Cleborne: So maybe to shift gears for a second, so one of the common critiques around active management is, jeez, if you’ve got a manager buying and selling stocks that’s going to generate capital gains, and one of the knocks on actively managed funds is they’re not terribly tax-efficient, and that you do risk seeing a fair amount of turnover in the portfolio and a fair amount of capital gains. So, Daniel, maybe I’d ask you to think a little bit about, can you talk to us about how to make sure that if you’re going to invest in actively managed products, that you’re going to invest in a way that makes them tax-efficient.

Daniel Wallick: Right. So the first thing to do is to think about what we call asset location. So typically, again not all the time, but typically active funds have the possibility of having a higher tax hit than index funds if there’s more turnover in the fund and if there’s cap gains to be realized in a variety of things. And so you’d want to think about putting those funds, if you have the opportunity, in a tax-sheltered account. Let’s just step back. That would be the first place to think about putting active were it available.

Jon Cleborne: And when you say tax-sheltered, you’re talking about a 401(k) or an IRA?

Daniel Wallick: Correct. Those are the two main places. Well, let’s just step back and think about the tax impact. There are two things that drive the tax impact in active funds. One is what’s the overall tax rate? Higher tax rates would be more. And, two, what’s the direction of the market? So if the tax rate’s high and the market is moving up, then there’s more tax to be paid. There have been times when Vanguard active funds would actually be very tax-efficient, but part of that has been when tax rates have been lower and the market’s been flat or down. So it’s not always that active funds are less efficient. But, again, if we’re suggesting long-term discipline, long-term horizon, it’s prudent to think about asset location when thinking about using active funds.

Dan Newhall: Yes, I think that’s right, Daniel, and so I’d say in a nutshell the kind of bar for active management is even higher. We know the bar is, you know, it’s hard. We talked about it earlier, the odds are against the average active manager. We’re trying to make a persuasive case for Vanguard’s active funds because of low-cost, disciplined management, but admittedly when you go net of fees and taxes, it can be done. And, as you just said, there have been periods of time there are funds that are actually fairly tax-sensitive and have even been worthwhile in a taxable account. But you just need to be really aware of that, and we do have other funds that are not tax-sensitive at all and really would be better off placed in a 401(k) or an IRA. So it’s just another, I think, part of the decision tree for an investor in an active fund.

Daniel Wallick: So if you have two, right, a lot of the investors calling in today or viewing today have both active and passive funds. So if you’re starting from that standpoint and you have an IRA or a 401(k), put your active funds there first. Fill that up to the extent and then we’d keep the index funds in your otherwise taxable account.

Jon Cleborne: I mean, you talked about active and passive together. Is it fair to think of this as another form of diversification?

Daniel Wallick: Actually, no. So, again, when we talked about the definition of active and passive, so passive is giving you the total market. What active is doing, giving you the total market plus or minus whatever the manager is deciding to do. So they both have the total market, right, so there’s going to be a lot of overlap of that. So I don’t really see that as the rationale to use that. If you’re buying an index fund, you’re going to get broad diversification by owning all the different stocks. Again, if you have a broad array of active managers or a market cap version of that, you’re going to get the same thing.

Dan Newhall: You’re also going to be well-diversified. Yes.

Daniel Wallick: Yes, right.

Jon Cleborne: And maybe continuing on this theme though for one second. So one of the things that oftentimes that Vanguard is fairly well-known for, and, Dan, your team is really responsible for this, is putting together different managers who have different philosophies into a single product. And there were some questions that came in prior to the webcast, and there’s actually a live question that came in from Peter who asks, “Are you using multi-managers because the products are becoming too large or are you using multi-manager, meaning you’re going to have multiple different managers on a single fund, because you believe those diverse strategies add value? So, Dan, maybe, can you talk a little bit about that?

Dan Newhall: Yes. If you think about it, I don’t think it’s wise for any investor to put all their money with any one manager and certainly not a concentrated manager because that would be perhaps not very well-diversified and pretty risky. So for many of our funds, we have both. Vanguard has a long heritage of single-manager funds. They’re very well-known and successful and really since 1991, I believe it was, with Vanguard Windsor II, we’ve had multi-manager funds. So we’ve done more with multi-manager funds in the last decade or so. I think, primarily, as the funds have gotten bigger, it’s allowed us to diversify the single manager risk. And so a fund with one manager, and especially if that manager is fairly high-conviction and concentrated, can be pretty risky and so to the extent that the fund has grown and it affords us an opportunity to add a complementary manager— So what we seek: We’re very careful about how we construct multi-manager funds. Whether we launch it as a multi-manager fund or whether we’ve added managers to it, the last thing we want to do is create a closet index fund, which I’m with you. But a closet index fund, to my mind, is an overdiversified fund at a high fee, and you might as well buy an index fund at a low fee. We do believe in diversification. And if you’re really thoughtful about whether you have manager A and you hire manager B to pair it with, if you’re really thoughtful about how that pairing marries up, I think you can improve the results for investors. You can certainly smooth out the variability. So any active manager’s going to have this kind of variability, and now I’m using jargon, relative to an index at any given period, they’ll outperform/underperform. If you can add another one whose maybe outperformance and underperformance isn’t at the same time, that’s good and healthy diversification. And it’s not diversification or closet indexing if that other manager has equal ability to add value over time. So Gus Sauter, our former chief investment officer, used to like to talk about this. If alpha or excess returns are additive, manager A can add 1% excess return and manager B can add 1% excess return, your excess return is going to be 1% in the long run, but it’s better to have both managers than one manager if they get there in different ways. You’re offsetting the risk of manager A.

Daniel Wallick: And if I could, Jon, so the research I’ve done, right, looking at the broad market, not just Vanguard funds but the broad market, is we don’t see any performance difference between multi-manager and single-manager funds. There’s just no material difference between the two of those.

Jon Cleborne: Interesting.

Dan Newhall: And a final, I think, interesting point is what hiring more than one manager has allowed us to do is hire some really pretty interesting, high-conviction, what we’d call them. Perhaps even some managers who we would probably never put in as a single-manager fund because they’re inherently very risky and very concentrated portfolios, maybe sector bets, etc. But if you pair that up with a few others, it can be a very interesting combination. Honestly, it’s what the most sophisticated investors in the world do. Whether you’re talking about endowments, they hire dozens of managers or defined-benefit plans. And I think for the average investor, they benefit on average from some diversification. Admittedly, if we’re very careful in curating that fund, and it’s not easy, but if we’re very careful about our selection and sort of curating of those funds, I think it can deliver very attractive results for investors over time.

Jon Cleborne: Well, unfortunately, we’re about out of time here. So maybe I’d just ask both of you if you have any final thoughts, closing thoughts?

Daniel Wallick: Again, I go back to Vanguard’s investment philosophy, right. We think for all investors to be successful, you need to identify what your goal is, have a balanced portfolio, consider low cost, and be disciplined. And that disciplined is not easy to do that. If we think about portfolio construction and active and passive, we think indexing is a valuable starting place for all investors, and then think about what it takes to be successful and active. And if you’re comfortable with that, then active is certainly an acceptable solution as well.

Jon Cleborne: Great, great. Dan, closing thoughts?

Dan Newhall: Yes, you know, I think all these questions are really important for investors to understand before you start purchasing active funds. And to understand that if you want to keep it simple, sure. Just index. I think there’s a strong argument for that. And you’ll do well. You’ll pretty much match the index, and you’ll outperform the average manager. But if you have an appetite for a bit of manager risk, active risk, you know, the way we’re doing it at Vanguard, I think we’re doing it as thoughtfully as it can be done. Again, starting with the low cost, but also it’s not just about low cost when it comes to active management. Low cost won’t get you there. You need truly talented managers. I think we have more than our fair share of that that we’re offering investors. And then the ongoing, it doesn’t end there. The ongoing, what we do full-time of monitoring these managers and their consistency with what they were charged to do. And even for our average investor, hey, read the annual report, read the semiannual report. Pay attention to what’s going on. If you have questions, send us a letter, ask questions. I think it could be, as you said, Jon, earlier, I think there are many investors who find it is a very interesting sort of thing to do, to sort of monitor how funds and managers are doing over time, and it can teach you a lot about our economy and the markets and these companies to read up on that. And it could be incredibly rewarding and has been for many of our investors and our funds over time. And I actually think the majority of our investors have some combination of active and passive in their portfolios.

Jon Cleborne: Yes, we certainly saw that from earlier today, right? So I think that’s a good note to end on. So thank you both for joining us. And thanks to all of you for spending your evening with us. Now in the next few weeks, we’ll send you highlights of this webcast along with transcripts and a full replay will be available on in just a couple of weeks. And we appreciate your feedback. If you want us to do deeper dives on anything we talked about today or if you have another topic you’d like us to consider, please take a moment and let us know. In your Web player, you’ll see that there’s a survey. It’s the little red widget at the bottom of the screen. Push it and tell us what you’d like to see. So from all us here in Valley Forge, thank you and we hope to see you again sometime soon. For more information about Vanguard funds, visit or call 877-662-7447 to obtain a prospectus, or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus. Read and consider it carefully before investing.

*Vanguard average active fund expense ratio: 0.27%. Industry average active fund expense ratio: 1.04%. Sources: Vanguard and Lipper, a Thomson Reuters Company, as of December 31, 2015.

**Source: Vanguard: Keys to improving active management success, October 2015

***Source: Vanguard and Lipper, a Thomson Reuters Company.  83% of Vanguard’s active equity and balanced funds outperformed their peer group average during the 10-year period ending January 31, 2016. 69% of Vanguard’s active equity and balanced funds have outperformed their benchmark gross of fees during the 10-year-period ending January 31, 2016.

Important information For more information about Vanguard funds, visit or call 877-662-7447 to obtain a prospectus, or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus. Read and consider it carefully before investing. 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. The competitive performance data mentioned in this webcast represents past performance, which is not a guarantee of future results. All investments are subject to risks. Services provided by Vanguard to the Vanguard funds and ETFs are at cost. Advisory services are provided by Vanguard Advisers, Inc. (VAI), a registered investment advisor. © 2016 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor of the Vanguard Funds.