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Emily Farrell: Hello, I’m Emily Farrell. Welcome to this evening’s live webcast about index and active funds. Tonight, you’ll learn more about their characteristics and how both could have a place in your portfolio.

So how should an investor allocate across index and active investments? Today, we’ll hear from two experts who can shed light on this very challenging question. Joining us are Daniel Wallick, a principal in Vanguard’s Investment Strategy Group, and Hugh Watters, a product manager in Vanguard’s Portfolio Review Department. Daniel, Hugh, thank you so much for being here.

Daniel Wallick: Thanks, Emily.

Hugh Watters: Great to be here.

Emily Farrell: Well, tonight we’re going to spend most of our webcast answering your questions, those that you’ve submitted in advance as well as ones that you can ask along the way.

Two quick items I’d like to point out. There’s a widget at the bottom of your screen for accessing technical help. It’s the blue widget on the left. And if you’d like to read some of Vanguard’s thought leadership materials that relate to tonight’s topic or if you replay a past webcast, there’s a green and white Resource List widget on the far right of the player. So does that sound good?

Daniel Wallick: It sounds terrific.

Hugh Watters: Perfect.

Emily Farrell: All right, before we get into our discussion, I thought I’d actually ask our audience a question. Right on your screen you’ll see our first poll question, which is, “Do you have active funds in your portfolio? Yes, no, or unsure?” So that’s a good simple one to get us started.

Emily Farrell: All right, so just take a second and respond, and we’ll share our answers in just a few minutes. All right, Hugh, so while we’re waiting for that, those responses to come in, and I think maybe we’ll get some interesting thoughts from our audience, maybe get a feel for where everyone sits, I thought I’d start out with one of the questions we got in advance, and we got a ton of questions about this topic.

Beth from Pine Island, New York. Hi, Beth. She asked, “What are index funds and active funds?” So I think that’s a really good place to start. Let’s start with definitions.

Hugh Watters: Sure. That sounds good. So index funds are sometimes referred to as passive funds. They seek to match the performance of an index as closely as possible. On the active side, they seek to outperform or beat the index over a period of time. So one’s just matching, and one is looking to outperform that.

Emily Farrell: Yes. So, I mean, I think it is really, you know, more of a simplistic definition, but I often hear you say “index,” but another word for that is “benchmark” as well, right?

Hugh Watters: Correct.

Emily Farrell: All right, great. So kind of building on that, you know, Dan, I’d love to go to you and talk about the advantages and disadvantages of each. William from Virginia, and William, I think you’re in Tappahannock, Virginia, so that was a tough one for me. Maybe you can talk a little bit about that.

Daniel Wallick: Sure. So the value of an index fund is it gives you broad exposure to an asset class or a portion of the market in a total concept way. The advantage of an active fund potentially is that it could provide even more performance than just the exposure to that asset class or that subgroup.

Emily Farrell: Okay, is there anything building on that a little bit more, Hugh, or advantages or disadvantages?

Hugh Watters: I just think another thing to watch out for really is just maybe the cost that’s involved there. So traditionally the active funds have a higher cost that’s associated with them, and so I think that’s a key component and certainly something that we’ll be talking throughout the next hour.

Emily Farrell: Absolutely. I think, you know, when we were talking about investments, cost is kind of top of mind and not something that’s a surprise to hear from Vanguard. So, I’ll take a pause right there because our results are in, and if you remember, our poll question was asking our audience about the active funds in their portfolio.

So just under 65% of our respondents said that they have active funds in their portfolio. Just about, a little over 22% said “no.” And just under 13% said “unsure.” And if those don’t add up to 100, it’s because they’re rounded, so just so you know.

So unsure, that’s an interesting question, right, Daniel? Any thoughts on that, or interesting point?

Daniel Wallick: Well, it’s interesting because the way things are labeled these days, it can be difficult to identify what your investment actually is, what your fund is, right? There are many funds that are called indexes that are actually active funds today. So when Vanguard talks about index funds, we mean a market cap–weighted index.

Emily Farrell: Yes, absolutely.

Daniel Wallick: Right, so just to clarify that point.

Emily Farrell: Yes, so at the beginning, knowing what you’re investing in, right?

Hugh Watters: Yes.

Emily Farrell: So getting to the point of about 65% of our respondents having an active fund, does that surprise you?

Hugh Watters: If I could, it doesn’t surprise me in that if you look at globally, right, about 20% of all the assets are invested on the equity side in index. So most people around the world invest in active funds. That’s where most of the assets are. So I think the audience today is reflecting that global weighting.

Emily Farrell: I think with all the news about index, growing, it could come as a surprise, but, obviously, again, still a really substantial part of the investable world.

Emily Farrell: So with that, I’m going to go to our second poll question. So to build a little bit on that, about our knowledge of our audience, right on your screen right now is your second poll question, which is, “Which of the following best describes your understanding of active funds, index funds, and the differences between the two?” So kind of a fundamental question to set the stage for today. “I understand them very well, I understand them fairly well, and I do not understand them at all.” And responses are already coming in, so we’ll get back to that in a second.

So, again, while we’re waiting for that, I have some more of the pre-submitted questions. Guys, lots of great questions, so you really do my job for me.

So let’s go to Vernon in St. Michaels, Maryland. He asks, “Are index and active funds mutually exclusive?” So I think I know the answer, but Daniel, you want to elaborate?

Daniel Wallick: Well, it’s interesting. It’s certainly a question on how to answer it. So very much so, what an index fund is, just trying to give you the broad market exposure. We often call that the beta. What an active fund is trying to do is give you that exposure, plus some variation off of that. And, hopefully, that variation is positive. So although they are different, right, active funds incorporate much of what passive are, plus additional elements.

Emily Farrell: Yes, it’s a really good question. You know, mutually exclusive. I guess it could have also meant in terms of your portfolio as well, right?

Hugh Watters: Yes.

Daniel Wallick: Right, so truly when we think about which investments there are, there are differences, right. A market cap–weighted index, as we talked before, that we think is sort of representative of the market, and that’s the way we talk about indexing. All other forms of investing are some form of active management, and there are many, many types of that.

Emily Farrell: Yes, absolutely. So, Hugh, I have a great question for you from Peter in Massachusetts. Hi, Peter. He asks, “Is it true that long-term returns,” so he says about ten years of index funds, “are greater than the average for managed funds?” So we’ll say active funds. “And in follow-up, is it also true that some managed funds beat index returns for a period of time but eventually fall back on the ten-year average return?” So getting right into performance here.

Hugh Watters: I’m glad we’re focusing on the long term here too—

Emily Farrell: Yes, me too.

Hugh Watters: —looking over ten years. So yes, I think that’s true that as a whole, active tends to lag the index funds and not do as well. But that’s not to say that they can’t or do. Some of them do outperform; it’s just a minority or it’s a subset of that.

And I think the second question really gets to the variability and sort of the timing of when you’re looking at these funds because active management performance can and will be quite lumpy from time to time, and I think Daniel’s group’s actually done some really good work on this where, let’s take 10 years, but let’s open it up to 15 years and look at the people who have outperformed over that time period, which I think was about 20% of kind of 2,000 or so funds that have been around that time, 98% of them underperformed for at least 4 of those calendar years. But over 50% underperformed for 7 or more years. So you might have gotten the performance over 15 years or 10 in this example, but you can see a great deal of underperformance kind of in between those particular years. So I think it depends on the timing as well, but it can be done. It’s just, again, the minority of active tends to outperform over that period.*

*Source: Daniel W. Wallick, Brian R. Wimmer, CFA, and James Balsamo. 2015. Keys to improving the odds of active management success. Valley Forge, Pa: The Vanguard Group.

Daniel Wallick: If I could, I think performance is a really critical question for a lot of people when they think about active and passive. If I could, there’s a story about a sumo wrestler that might be useful here.

Emily Farrell: All right, this is going to get interesting.

Daniel Wallick: So, if we think of all the investments as a baby and a sumo wrestler, right, so they’re two investments. Like one’s a baby, and one’s a sumo wrestler. We can either count those, right, or we can weigh those. So when we count them, we come up with the numbers that Hugh just identified. If we count the managers, those are the percentages. If we weigh the dollar, where the dollars are, the numbers are actually slightly better for active management.

So if you look at it over a ten-year period, and you weigh the dollars, a majority of the managers will outperform before they charge you any fees. But after they charge you fees, it’s probably only about 35 or 40% of them will outperform. So it shows you the critical nature of cost in impacting the final results of active management.*

*Source:Garrett L. Harbron, J.D., CFA, CFP®; Daren R. Roberts; and James J Rowley Jr., CFA, 2017. The Case for low-cost index-fund investing. Valley Forge, Pa: The Vanguard Group.

Emily Farrell: Cost, I mean an absolutely recurrent theme, and you heard it here first. Sumo and the baby, I’m going to remember that. I worked with you for a couple of years. That’s the first time I’ve heard that, so lucky me.

I’m going to take another pause because our responses are in, and what we were asking about was understanding of active and index funds and the differences between the two investments. Again, getting to the real heart of why we’re here tonight.

So about 33+%, “I understand them very well”; 48%, more than 48%, “I understand them fairly well”; and 18%, “I do not understand them at all.” And, again, don’t check my math because I didn’t count all the rounding.

So “I do not understand them well,” you know, nearly a fifth of our respondents. So it’s interesting because we talked about active and index and the differences between the two. And maybe, perhaps, to unpack that a little bit, it could just be maybe it’s active funds or maybe it’s index funds. Any reactions to that?

Daniel Wallick: Yes, I do think that the primary issue is what asset class are you investing in, right? Are you investing in stocks, do you want to invest in stocks or bonds? That’s really the first question to think about answering. And then within those asset classes, there’s always the decision do you want to be active or do you want to be passive? And, again, I do think the question of what is active and what is passive has gotten blurred recently, right, and so these definitions can be challenging. So I’m not surprised that people feel it somewhat, but the terms really get jumbled. So, again, we would go back to a market cap–weight index is an index. Everything else is some form of active management.

Emily Farrell: Hugh, anything to add? I mean you work with investors all the time. Continued confusion over what they’re investing in?

Hugh Watters: Yes, I think that the line that Daniel mentioned of getting blurred with more and more products coming out, you’re seeing a lot more of that. So the education on what you’re invested in and the asset allocation is really where we’re trying to bring the conversation back to. You know, there’s a lot of information out there. They’re reading headlines every single day, and that’s really a headwind, I think, against us where we’re trying to just reiterate what Daniel mentioned as market cap–weighted. Anything outside of that is an active decision.

Emily Farrell: So, I’m going to get back to performance for a second because we had a great question come in. It was a good follow-up for what we were just talking about. And James asked us, “So, how do you choose an active fund that may outperform a comparable index fund?” So, that really kind of gets to the heart of it.

Daniel Wallick: There you go; performance and how to identify it.

Emily Farrell: Hugh, you want to kick it off?

Hugh Watters: Yes, sure. So we, obviously, have a long history of offering active funds, and the three key factors that we have found are talent, cost, and patience. So in talent, we’re very qualitatively driven, so what we focus on, the firm, the people, the philosophy, the process. That helps us identify what, I’ll say, world-class managers.

Cost, we’ve talked about this, but that is the leading indicator to outperformance longer-term. Right, so the higher the cost, the higher the hurdle for outperformance.

And then patience. We alluded to this a little bit with some of the studies we were talking about, but active management will be lumpy. We call it the bumpy road to outperformance. So you need to have patience to really unlock that active management, and I think some of the stats, obviously, we’ve thrown around. So the talent, the cost, and the patience are really the three key aspects to identifying successful, long-term active managers.

Emily Farrell: Yes, I mean it seems fairly straightforward, and we know it’s not always easy, and that’s why your group spends their time thinking through those things every day. And you and your team of researchers have been looking at this for years. That long-term piece too. I mean you even challenged our question to the extent from 10 to 15 years as well.

Hugh Watters: Yes.

Emily Farrell: I have a live question already, so this is great. They’re already coming in. And Sanjay asked us, “Does it make sense to have both active and index funds in a portfolio? If so, when and why?” So the last question was a little bit of a vice versa question, so can we do both? Daniel?

Daniel Wallick: So, if I’m building a portfolio for somebody and I don’t know anything about them, I would put them in an all-index fund. And then to the extent that the individual investing is comfortable with the attributes that Hugh just described, right—talent, costs, and patience—if they think they can identify talented managers or their trusted advisor can, if they can acquire that at reasonable cost, and then if they can be patient with active, then active can potentially have a role in the portfolio also.

You’d need to make sure you’re comfortable, particularly with that variability through time, because an active manager is actually trying to be different than the index.

Emily Farrell: Yes.

Daniel Wallick: So, sometimes they’ll be successful and sometimes they won’t. Right, there’s not going to be an absolute pattern of that. And so if you can be comfortable with those attributes and you can acquire it at the low cost and you think the manager’s talented, then there’s a potential role in the portfolio for that.

Emily Farrell: So indexing as a starting point and then assessing kind of your unique situation for tolerance, etc.

Daniel Wallick: Right.

Emily Farrell: All right, I want to take a pivot here because Ann asked us a great question. It really gets back to the cost discussion, which is so crucial. She asked, “Please discuss all the types of fees, management, commissions, sales charge, load, operating expenses, and taxes.” So we only have a certain amount of time but Hugh, could you talk a little bit about what should an investor be thinking about when they’re thinking about cost?

Hugh Watters: Yes, I mean I think there’s two key components, right? There’s the cost in which we’re paying the actual manager to run this, so that talent piece that I mentioned. Right, there’s a cost involved with securing world-class talent that we think can outperform over the longer-term period. And that can be, in the case of Vanguard, there’s generally a variable cost as well, based on the performance of a particular manager. And there’s obviously the Vanguard piece, right, the economies of scale that we bring to the table that as the funds get larger, you know, we inherently have this mechanism to lower the fees over time, given our sort of unique ownership structure.

Emily Farrell: Right.

Hugh Watters: So I think you just need to be aware of how much other managers’ taking of that overall fee and is that worth really the performance that they’ve been able to deliver over a longer-term period.

Emily Farrell: Yes, I would imagine it’s a little confusing though because at the end of the day, if I’m the investor sitting there with my fund information, what should I be focusing on?

Daniel Wallick: So there’s two things, and I think she raises those questions. One is expense ratio, which is what Hugh was identifying there, and that should be disclosed for every fund, and you can find out what that number is as a fee. So you want to look at that.

If you’re buying that directly, perhaps from Vanguard or somebody else, you’re not paying any of the marketing fees or any of those. But then the other issue would be taxes, and I think she raises that, and that’s an important thing to address.

Emily Farrell: Yes, exactly.

Daniel Wallick: You know, a simple rule of thumb would be, to the extent that you want to use active, put it in tax-deferred accounts to the extent that you have that first, and then look at it in taxable accounts because then you’re sheltered from any of the tax issues that could occur in the active funds. And active funds tend to have more activity in them, so their tax bills tend to be slightly higher, on average. Not all, but on average.

Emily Farrell: Sure. Yes, and your broader team has looked into this quite a bit, right?

Daniel Wallick: Yes.

Emily Farrell: So we have one last, at least now, live question. I’m hoping that they’re going to continue to come in, and Marvin asked us, “Do all index funds have ‘index’ in their title or do some mutual funds behave like index funds without ‘index’ in the title?” So, Daniel, you kind of alluded to this a little bit earlier when you were talking about identifying what you’re investing in.

Daniel Wallick: I think the most critical step would be, the term “index” used to mean one thing, and I used to not have to explain the difference. But today, I really feel every conversation I have, I have to explain the difference.

Emily Farrell: Yes.

Daniel Wallick: Again, when we talk about market-cap indexing, we think it’s market cap–weighted, and what that’s doing is taking a weight of all the securities that are out there and identifying that as what the market is identified, right, and weighing them all.

The other things that are called indexes, like fundamental indexes or other things like that, those are not market cap–weighted indexes. Somebody’s making up a set of rules and running a regression or running a process to identify security selection that way. That’s a form of active management. It has indexing in the title, but it’s a form of active management. So it can be very confusing today.

There are active funds that can be closely matched or be close to a market cap–weighted benchmark, but they’ll have a different name. And so the confusion, I think, mostly comes today when all the different things that are called an index and keeping your eyes out for a market cap–weighted index, if that, if you’re looking for a passive investment reflecting the market.

Emily Farrell: Yes, so, again, really just kind of delving into it.

Hugh Watters: Yes.

Emily Farrell: So I have a bunch more questions. I’m going to keep going, and, Dan, I’m going to go back to you with this one. Diane from Wisconsin asked us if there are certain sectors that make more sense to be in active versus index. So, again, it’s an application of that decision.

Daniel Wallick: Right, I was actually just up in New York talking to some people, some professionals in the business. They asked me the same question.

Emily Farrell: Oh, good, there you go. Diane, great question.

Daniel Wallick: It’s a frequent question we get. Our research that my colleagues and I have done would identify that there’s no particular place, subset of the market that is easier to outperform than another, and there’s no time in the market cycles that is easier for active management to outperform. Really, it comes back to what Hugh had mentioned earlier, which is for active to be successful, you need to identify talent, you need to acquire that at low cost, and you need to be patient with it. And that can be applicable in any market segment.

Emily Farrell: Yes, there was actually a part of one of your earlier questions, and perhaps we kind of alluded to this, but it seemed like there was an inference of is there kind of a cyclical aspect to performance with active funds? So would you say not the case?

Daniel Wallick: No, we haven’t found that in particular. I do think there’s a sense, sometimes there’s greater deviation so there’s a wider range of results, and some people see that as maybe that reflects easier. But we find that under any circumstances you tend to have an equal number above and below that situation. There really are no consistent patterns that you can identify ahead of time that we found that lead to any one part or another being more successful for active.

Emily Farrell: Okay, definitely good. Something to keep in mind. So, Hugh, I have another question that gets into that, kind of another element of the decision-making process. And Barton from Miami, Florida, which hopefully Barton’s having some good weather down there in Florida. He says, “I’m retired with a short time horizon. How does that affect my choice?”

Hugh Watters: Yes, I think that time horizon and that patience, and that’s the conundrum here, right?

Emily Farrell: Sure.

Hugh Watters: Looking at active versus passive. But if I’m retired, I think there’s another question there about what’s my risk and what is my time frame, and what sort of volatility or variability in those returns can I really accept at this particular time frame? So there are some active funds that have, less volatile, that are similar to sort of index funds. But with the short time frame like that, that would challenge I think that patience aspect that comes with the active management. So, I think active may be a little bit more challenged given that time frame, and plus in retirement, you’re probably looking to preserve that capital relative to building that or being in an accumulation phase.

Emily Farrell: Yes.

Daniel Wallick: Yes. If I could, the one overlay on that, and I do agree with what Hugh said, the one overlay is, what’s your individual risk tolerance? If you have a very high risk tolerance, then maybe you’re more open to taking active. And what I mean by risk tolerance is accepting the chance that you’re right versus that the possibility you could be wrong. Right? If you’re willing to accept some variation in those outcomes, then maybe active continues to have a role for you, right?

Emily Farrell: Yes. I know. I have a long time horizon until my retirement, and I am fairly risk-averse, so there you go. So it doesn’t necessarily equate to the way you trade.

So, again, more of these decision-making factors that have been popping up in our questions. Daniel, Bill from Cranberry Township, right here in Pennsylvania. He asked, “How do you decide what proportion of this stock portion of a portfolio should be devoted to index versus active funds?” So, again, we’ve made our overall asset allocation decision, stock/bond. Thinking through the stock, index versus active?

Daniel Wallick: We actually have a chart that might be helpful here. It’s the bar chart; if we could put that up on the screen for people.

Emily Farrell: Sure.

Daniel Wallick: One of the things we did was we just published a paper on the factors that you need to look at to think about using active and passive together.

Emily Farrell: Right. And just a quick pause, that’s actually in your Resource widget here if anybody wants to take a look at home.

Daniel Wallick: Great. And what we identified was to use active, you really want to be explicit about picking where you are in four critical areas. One is what is your alpha expectation for the fund? How much outperformance do you think is going to exist? And, of course, if you don’t think the manager is going to outperform, then it’s better not to use the active fund, just to be clear. What’s the cost of that fund? What’s the risk of that manager? So what’s the variability? What’s the chance of just up and down, the variation that’s going to happen, because we don’t know that for sure that that alpha expectation’s going to exist, right, so what’s the range of that? We often call that tracking error. And then what’s our personal risk tolerance? Because if we don’t, as you were articulating, right, if one doesn’t have a willingness to live with the chance that you could be wrong, then it’s better off staying in indexing.

Emily Farrell: I’m never wrong.

Daniel Wallick: There you go. But to the extent, perhaps your husband, right, is a different risk-taker—

Emily Farrell: No, he’s wrong.

Daniel Wallick: —is willing to take that risk, you have to be comfortable with the variation through time because as Hugh said, “The only way to capture benefit through active management is to hold it for a long period of time.” So what’s our risk tolerance with living with those swings?

Emily Farrell: Absolutely.

Daniel Wallick: And so the point of thinking about active/passive is if you can be explicit about where you are, high, medium, or low perhaps on each of these factors, there’s a mathematical exercise you can go through and do and find what’s a reasonable target?

Emily Farrell: So we have a clarifying question. I think this is really fundamental, so I want to go back to it. And Sheila asked, “What does market-cap weight mean?” So market capitalization, right, and what does market capitalization–weighted mean? That’s like a mouthful.

Daniel Wallick: We can go back to the sumo wrestler.

Emily Farrell: And the baby.

Daniel Wallick: And the baby, right. So you think about the sumo wrestler, the baby, we’ll throw in a teenager and an adult, and that’s four different stocks. So what market-cap weighting does is it weighs every one of those stocks, right, and the total market is the weight of them all. So we don’t count them equally, right, because some are bigger than others, and that’s what we’re doing in market cap.

Emily Farrell: So just to kind of maybe give a little example. For instance, one of the markets could be the total U.S. stock market, right?

Daniel Wallick: Correct. And what we’re doing is weighing the amount of every stock. We’re capturing in the index all of the stock that’s in public circulation, without making a judgment of one versus another. We’re just taking that clearing house, and we’re taking the market clearing. Right, we’re taking the use of all the investors and all of their expectations, right, to identify the price. And that’s what we do, as opposed to other indexes will say, “I’m going to filter by certain criteria.”

Emily Farrell: Sure.

Daniel Wallick: So a manager or somebody has made the decision that I’m going to filter based on how many dividends they pay or are they a good value stock or are they a small-cap stock, are they a blue stock or a red stock—whatever it might be. But somebody’s made that judgment and then filtering. What market-cap weighting is doing is not making any filters on that.

Emily Farrell: Right. So in a really kind of CliffsNotes type of version, would you say it’s capturing the entire market of a chosen market? So capturing the entire U.S. market, U.S. bond market, perhaps the 500 S&P, that kind of thing, right?

Daniel Wallick: Right.

Emily Farrell: Okay, hopefully that clears things up because, you know, again, market cap, we’ve talked quite a bit about that one. I want to make sure that we know what we’re talking about.

Daniel Wallick: Well, I think it’s a particularly important point now because there are many, many things called index funds.

Emily Farrell: Exactly.

Daniel Wallick: And not all of them are market cap.

Emily Farrell: Absolutely. All right, so some more questions about the decision, these inflection points that might point you to active versus index. So, Hugh, Brock from Kansas asked us, “Timing market dips for adding funds?” So timing market dips. All right, I think we have some radar going, right? Huge upside or little value for the small investor building long-term?

Hugh Watters: Well, I think the simple answer is little value for the investor, and I think Daniel already spoke about this briefly that we’ve looked at different market cycles, different approaches by style, by size, U.S., non-U.S., and we haven’t found any consistency or any hallmarks to saying somebody’s going to outperform in this type of environment.

So I think you’re probably better off looking at the asset allocation and adhering to that asset allocation through different market cycles. That’s probably a more powerful tool than trying to time a market, which we have found that’s very difficult to do.

Emily Farrell: So a good follow-up to that, actually another question that came in from Dan in New York, Saranac Lake, which sounds very pretty, doesn’t it?

Emily Farrell: So, again, it kind of talks to market timing, but there’s a little bit more specificity here. In the event of a sharp market downturn, 20% or more, do managed funds have the ability to recover their losses sooner since they are not obligated to follow an index? Hugh?

Hugh Watters: Yes, I think it’s similar. There’s a timing aspect. There are some funds that have certain characteristics that tend to perform a little bit better in that type of environment, meaning it will lose less when the market goes down. But, again, this patience and this consistency and this somewhat randomness from shorter time periods of active management, it’s tough to say, “Yes, this type of fund will do well in this type of environment.” All the research that we’ve done kind of shows you the opposite, that it is, there’s a volatility factor there.

So, I would say no. There isn’t going to be anybody who’s going to be consistent to return your money much more quickly once it loses.

Daniel Wallick: Well, in both those questions that you ask, we’ll know after the fact—

Emily Farrell: Sure.

Daniel Wallick: —as opposed to before the fact, and that’s the challenge.

Emily Farrell: Got to dust off that crystal ball.

Daniel Wallick: Yes, exactly.

Emily Farrell: It is funny. You talk about patience; you talk about risk tolerance. There’s a little bit of almost like a human correlation there, isn’t there?

Daniel Wallick: Yes.

Emily Farrell: All right, so, Daniel, when we are thinking about combining index and active, and as your team has done quite a bit of work, and as a reminder, the paper is in actually that Resource widget, so you might want to take a look.

R. in Denver, R., very mysterious, asked about combining index and actively managed funds, and he wants to know how do you mitigate the risk of overlapping asset holdings? It’s a great question.

Daniel Wallick: Yes, I don’t think you do. I think you have to accept that, right. I mean if you think about an active manager, what they want to do is overweight the stocks, right, that they think are going to outperform and underweight the ones that they think are going to underperform. So, by nature, that’s what they’re doing. And so if you combine active and passive, inherently you’re getting some overweights and some underweights.

So that’s sort of, you need to accept that if you’re going to go the active route. More of some things, less of others.

Emily Farrell: Yes, again, it’s part of that active decision that you’re making by having active funds in your portfolio, right?

Daniel Wallick: Right. And you’re entrusting a third party to, hopefully, be educated on that point and be successful in doing that.

Emily Farrell: Absolutely. All right, Hugh, so another question from Carolina. Carolina didn’t tell us where she is, so hope you’re out there, Carolina. “When investing in active funds, should one focus on investments that pay quarterly dividends?” Dividends popped up. It was a buzz word before. And she asks, “Is there any advantage to a stock with dividends than one without?”

Hugh Watters: Well, I think this gets back to depending on what your needs or your investment goals are as well. So dividends, if somebody enjoys income or wants that too, you can get that on a quarterly basis through some of the dividends. If somebody’s looking to, I’d say, save for something longer-term, they can embrace dividends and reinvest that and unlock the compounding effect, which can really help them reach that particular goal. So dividends can certainly play a role.

And I think that second part about, I think it was stocks, dividend-paying stocks—

Emily Farrell: Yes.

Hugh Watters: —let’s open that up to let’s say a dividend-paying fund that has a focus on income or dividend, it does have certain characteristics, and I alluded to this a little bit before that they tend to be less volatile. They tend to have better kind of that downside-type protection, but the trade-off is on the upside; it may not do as well as the broad market in a very up and strong type market. So what are your risks? What are your preferences? Are you more concerned with the downside and losing money or am I indifferent to the market? These are things to sort of take into account. But if somebody’s a little bit more worried, then less volatile, they tend to have those kind of characteristics so that could be a good fit.

Emily Farrell: So maybe we should probably take a quick step back and just talk about dividends too, so real quick definition.

Hugh Watters: A company sharing the profits with you. And then as a fund, we pass that on to you probably on a quarterly basis or an annual basis, so it’s income to the end investor.

Daniel Wallick: And so if I could?

Emily Farrell: Sure.

Daniel Wallick: So some people with the low bond yields today, and they’ve been low for a long period of time, who’ve been comfortable with the coupon income from those bonds, look to potentially substitute a dividend stock for their bonds. That’s a pretty radical difference. And so that we would caution against because you’re taking a different risk profile. You really want to be comfortable with that risk profile before you did that.

Emily Farrell: Yes, absolutely. And that gets into the whole conversation of the role of equities and bonds in your portfolio too.

Daniel Wallick: Right.

Hugh Watters: And that could be why this question is coming up, right. We’ve been in such a low-yield environment, and certainly we’ve seen a lot of cash flow because they’re perceived safety-type investments. So we’ve seen a lot of interest in this in the last few years. So it’s a good and it’s a very timely question.

Emily Farrell: Yes, so you’re saying we’ve seen a lot of, should we make that replacement decision?

Daniel Wallick: Correct, right. It’s a question a lot of people are asking, right, because—

Emily Farrell: Yes, and it makes a lot of sense. Again, like you said, low-yield environment.

All right, so I have a great live question and wanted to talk to you about—and this is from Dave—”Why not use fund performance as the major decision factor? For example, why not choose a fund based on performance over a period like 30 or 120 trading days as indicated by a moving average?” All right, this is it, right? Come on, Daniel.

Daniel Wallick: So if I could, right, we did run some research that tried to look— In academic terms, it’s called ex ante, which is, is there anything that signals us ahead of time to indicate future success? And Hugh mentioned this a little bit.

And so we looked at everything. We looked at fund size, we looked at past performance—looked exactly at what Dave had suggested there—we looked at fund size, age of the funds, concentration of the funds; either they have a little bit of stock or a lot of stocks. Number of stocks. And the only thing we found that was predictive of future success was cost. So more expensive funds underperformed lower-cost funds. That was the only thing that was statistically significant. Right, so that’s the only thing that mattered ultimately.*

*Source: Daniel W. Wallick, Brian R. Wimmer, CFA®, and James J. Balsamo, M.Sc. 2015. Shopping for alpha: You get what you don’t pay for. Valley Forge, PA: The Vanguard Group.

And while all of these other things feel somewhat intuitive, like they should sort of influence the decision, we didn’t find any evidence of that. That’s why, again, we talked about talent, cost, and patience. That’s why cost is such an important part of active success.

Hugh Watters: Yes, and I think just adding on that, right, I didn’t mention anything about performance when we mentioned talent, cost, and patience. And even from a search perspective, when we look for new advisors and we’re evaluating it, we’re more qualitatively because, performance, it’s variable and it doesn’t have that predictive nature, so kind of focusing on that talent, cost, and patience. If we get that right, the performance will come longer-term.

Emily Farrell: So, Hugh, you just mentioned search, and I know quite a bit about what your team does. And we got a question from Bruno in New Hampshire that I think we might be able to unpack a little bit about what your team is doing with our active managers. So he asked, “Does Vanguard have more than one manager for its active funds? Don’t these funds end up being index funds in disguise? And why can’t more Vanguard active funds be run by one manager like the Vanguard funds run by PRIMECAP?”

So there is a lot there. So, first, I’d love to talk a little bit about your team, and you mentioned this search function, what you’re doing every day.

Hugh Watters: Sure. So I think we have significant assets or resources, let’s say, put at this oversight of our mutual funds as well as finding new advisors. Twenty-plus person team. Primary responsibility is really looking after this particular book of business. And it’s not just our team as well; it’s senior management as well as our board of directors at Vanguard. So we have a multilayer process for this oversight, and we have a continuous search function. So we see 150, 200 managers a year to really identify backups for all of the managers that we have. And that really just allows us to feel a little bit better in the event that we have to make a particular change, but a dedicated team focusing on these qualitative aspects and sometimes taking 3, 4, 5 years to get comfortable with a particular firm to ensure that they’re aligned with Vanguard’s philosophy and process because our tenure with these firms is 14 years at present; so we are a buy-and-hold type manager, and we want to do a lot of research up front to ensure that we get the correct fit, if you will, so that we’re not making a change every kind of 12 or 18 months because to that timing question prior to that, you can’t time these managers and that can be disruptive to the fund itself or the investors.

Emily Farrell: So your team is, in essence, scouring the globe every day for talent. We have aligned with close to 30 external managers that we consider the best of the best who are managing our active equity funds for the most part.

So now Bruno from New Hampshire, going back to his original question, and I kind of co-opted it a little bit, so you’ll have to forgive me, but he talked a little bit about one manager of active funds versus multi, so maybe you can get into that and explain the two different structures.

Hugh Watters: Sure. So, first, I think we have a slide too that we can use the multimanager funds just to give you a breakdown of what it actually looks like. So we have embraced both approaches. I think we have more assets in the single-managed funds. Relative to the multi, it’s probably a 60/40 type split, but it’s certainly something that we’ve embraced over time.

The multimanager funds, I think what that really delivers to us at the end of the day is it diversifies away from single-manager risk, it gives us a more diversified active portfolio, and if we can combine distinct yet complementary managers, we have the potential for more predictable return streams; i.e., less volatile in the active-type approach. So those are three key aspects of the multimanager approach for us, and it’s something actually we’ve been using for about 30 years now. So it’s not something that’s new for Vanguard. It’s something, this pairing of managers and diversity of thought that we’ve embraced for quite some time.

Emily Farrell: Yes, I think your math is right. I think we’re about 30 years this year, in fact.

Hugh Watters: Yes.

Daniel Wallick: Emily, if I could?

Emily Farrell: Sure.

Daniel Wallick: So we’ve also written some research that looked not at just Vanguard funds but the entire market at both single-manager funds and multimanager funds. And what we found was there’s no distinctive difference in performance. So one wasn’t necessarily better than another. It was also in that research I just previously mentioned about is there anything that’s predictive? So that wasn’t predictive, single manager versus multimanager. And if you look at performance in aggregate, the performances are pretty much indifferent. You’re really looking at other factors to identify success.*

*Brian R. Wimmer, CFA and Daniel W. Wallick. 2013. Analyzing multi-manger funds: Does management structure affect performance? Valley Forge, Pa: The Vanguard Group.

Emily Farrell: Right, so Bruno actually asked specifically, “If you start putting too many managers together and compiling them in a multimanager structure, does it actually end up being an index fund in disguise?” So I guess the short answer is “no,” right?

Hugh Watters: No. And I think also from that multimanager, something we look at very closely is what is the correlation or how do they work? Do they work together in tandem or they work in opposite directions? So we want managers who have low correlation of projected excess return or positive return. And that’s something we monitor, and that’s how we pair distinct yet complementary managers to dampen that volatility. So, in theory, yes, you could continue to pair together low-correlated managers and still look very different relative to the benchmark.

Emily Farrell: Yes, so we’re talking about constructing these funds, and that’s what your team is doing day in and day out with those different management teams that we work with. And I think a good follow-up to that is Luke had asked us, “If you’re using an active fund, why not DIY a fund? Isn’t using an active mutual fund already implying that you believe you can beat the market? If so, why not use that knowledge to pick stocks without management fees?”

So, Daniel, I think that’s a great question. Can you take it from there?

Daniel Wallick: Well, I mean if an individual feels that they can do that, they should certainly do that, right? I mean that’s what a professional is trying to do who’s managing a fund. I think the challenge typically is do we have enough bandwidth, do we have enough time to be able to do the full research? Because when Hugh goes out, and he can tell you about the firms that he hires, I mean there are fleets of people who are spending all of their time looking for value in stocks. So it’s a big job. And, again, to the extent that people have the wherewithal or the aptitude to do that, God bless them.

Emily Farrell: Time, willingness, or inclination, right?

Daniel Wallick: Yes, they should go and do that. Our experience would be just it takes a lot of time and effort, and it’s an incredibly competitive space these days, right, to be able to do that. But I don’t know, Hugh, if you have more to add.

Hugh Watters: Yes, I think you’ve summed it up quite well. I mean I think the time, the costs, getting diversification as well, something that you can get very easily I think through a mutual fund and talent that way.

Emily Farrell: Yes, the cost piece there, we can’t escape it, not when you’re talking to us, right?

So we’ve got a couple questions, including a live question, about types of active funds and maybe some different categories that you might see associated with active funds. So Lori-Jo asked us, “Can you explain the difference between growth and value active funds?” Hugh, can you talk a little bit about that?

Hugh Watters: Sure. So I think from a growth perspective, these tend to be certain sectors like technology or health care. And these are generally firms that put their money back into the business, and they will grow very rapidly or very quickly.

On the value side, they tend to be slower movers. They tend to be a little bit more mature from that aspect, and they will pay dividends from that aspect as well. So growth tends to have a little bit more, let’s call it momentum, or a little bit more volatility, where value tends to have less of that call and momentum factor.

Emily Farrell: And a good follow-up to that is Joe from Idaho had submitted us a question, and he asked if we consider factor investing to be active investing? And I think we’re hearing a little bit more about factor in the news and the headlines right now.

Daniel Wallick: Right. I would say there’s three big, giant categories of active management. Clearly, factors is one of those. Traditional, long-only public investments like the funds we’ve been talking about are one. The other I would put out there would be any private alternative. So private equity or hedge fund, those are all forms of active management. Anything other than a market cap–weighted index is some form of active management. And certainly factors has been getting a lot of headlines these days and attention about potentially the next wave of activity in the active space.

Emily Farrell: Yes. So, again, at the end of the day, it’s looking at what these categories or types of funds are and what is the purpose of the fund, what is the strategy behind the fund? Just like you’re trying to discern index versus active, when you’re looking at value or growth or a factor fund, again, it’s what is the fund trying to do, right?

Daniel Wallick: Right, and we’d often suggest this is where working with a trusted advisor or somebody who you’re comfortable with who is an expert in the field or knows something about the field can be helpful in guiding through that. If you don’t feel comfortable doing that yourself, talking to somebody who can help you through that is certainly a good way to approach that.

Emily Farrell: Yes, absolutely. So this is a really interesting question, and it’s something that I feel like is a little bit more of, like, a buzzy topic right now. Michael from Brooklyn asked us if we can discuss the risks associated with massive amounts of money flowing out of active management and into passive management. In other words, its impact on market efficiency. So we’re all seeing the headlines, right? Everything’s moving towards indexing, supposedly.

Hugh Watters: Right, is indexing getting too big? That’s the general question. And I think the answer from our end is “no.” And certainly indexing is getting a high degree of market share at the expense of high-cost active, but when we look at what indexing represents globally, the equity market, it’s less than 20%. It’s kind of in that 15 to 20%. If you look at the fixed income side, it’s actually less than 5% globally, so it’s still very much a modest amount of that overall piece. So we think that being so small, indexing isn’t getting too big and isn’t having the effect that the headlines would lead you to believe.

Emily Farrell: Right. Yes, again, it goes back to that high cost/low cost. And, in fact, some of your colleagues have written about this and studied the investor behavior, and really it is that movement towards an acknowledgement of cost in terms of investment decisions.

Daniel Wallick: Right. So people have identified that, and I think there has been, as the headlines have identified, sort of an increased flow to indexing. But given where all the assets historically have been, that hasn’t moved the aggregate dollars, as Hugh was talking about. They’re still only about 20% in the index, at least in the equity space.

Emily Farrell: Absolutely. All right, well, so a very simple “no” there.

Daniel Wallick: Yes.

Emily Farrell: But some really helpful context too.

Emily Farrell: All right. So do you have a CliffsNotes version of how to say basis points?

Hugh Watters: .01.

Daniel Wallick: Yes, there you go.

Emily Farrell: There you go, is a basis point. A hundredth of 1%, right?

Daniel Wallick: A hundredth.

Emily Farrell: Yes, it’s 100 basis points. Right, there we go. All right, because I don’t want to confuse any of our audience at home.

All right, so we have another clarifying question, I should say, from Steve asking about factor funds, “What are factor funds?”

Daniel Wallick: So, factor funds are funds that look to break the total market into the elements that drive returns. So what they’re trying to do, there’s been a lot of academic work looking at what components of the market can we identify them that would drive the returns? In the equity side, Hugh was mentioning some of these earlier, one is size. So do small-cap stocks drive more of the performance than large-cap stocks? Or do value stocks outperform more than growth stocks?

Hugh Watters: Growth dividends, right.

Emily Farrell: There you go.

Daniel Wallick: So they look at all of those. And often an easy way to think about it or the easiest way is in the fixed income space, so bonds. There are two key factors that tend to drive returns in bonds. One is the duration, so the length of the bond, and the other is how much credit versus government investment is in that. Those tend to be the two key levers that drive that, and so what factor funds are doing are investing in just individual elements of factors and no security selection.

Emily Farrell: All right, that’s really helpful. Okay, great. We have another live question, and we’re pivoting a little bit back to cost. So how can one determine the management fee for a given fund? Hugh?

Hugh Watters: You should be able to look at a website, prospectus. Prospectus usually breaks down the management fee and the other costs that roll up into the overall expense ratio or the overall cost that you’re paying. So, I think the prospectus is probably a good place to start, and they should be available from any provider on their website.

Emily Farrell: But isn’t it fair to say that at the end of the day, the all-in cost or the expense ratio is really what the bottom line for an investor should be?

Hugh Watters: That’s what you’re going to pay.

Emily Farrell: Exactly, right. So even if there was kind of variations within the management fee, it’s again, looking at that bottom line, right?

Daniel Wallick: Yes, as mentioned earlier, you want to look at your total costs, right?

Emily Farrell: Exactly.

Daniel Wallick: So, independent of your tax situation, because you only know that after the fact, right, but in terms of what you’re going to pay, you want to look at the expense ratio.

Emily Farrell: All right, another live question. Harold asked us, “Why are some Vanguard funds closed to new investors?” Hugh, can you kind of explain the decision behind that?

Hugh Watters: Sure. So as an active manager, I’m trying to outperform a benchmark or an index sort of over time, and in certain segments of the market, I may only be able to run a certain amount of money, or we refer to it as capacity, in a particular area. And when you get to your capacity, it may affect your ability to deliver the returns that you have done historically.

So to really protect the current investors and for them to receive, hopefully, the same performance that they’ve gotten historically, sometimes we have to limit cash flow or we have to close to new accounts in order to really protect the current shareholders. So we’re not just gathering assets for the sake of becoming larger. We’re trying to be aware of the clients who are our owners and capacity. And in certain areas, we need to be aware of that to really, again, entrust or ensure that that alpha or that performance can be delivered at some point in the future. So, it’s really protecting the end investor.

Emily Farrell: Yes, absolutely. And a definitely long-standing practice.

So I’m going to go back to a question that I received well before the start of our webcast, and we talked a little bit earlier about taxes. And Tom from Minnesota asked us, “I have some actively managed funds in my taxable account.” Okay, so I think that’s key. They generate more capital gains than I would like. Are there any options to reduce the resulting tax consequences?” Daniel?

Daniel Wallick: So there is a strategy you can use as opposed to a fund investment, and the tax strategy would be tax-loss harvesting, where what you do is when you have a tax bill, you take that loss and then you move forward. And an advisor or a financial advisor of some type or a financial planner can try and help you with that through time. That’s the one thing you can do once you’re in that.

The other would be where does the incremental dollar go? As we mentioned before, if you don’t like the capital gains impact that you’re getting from the active funds, then in the future invest the incremental dollar in a tax-deferred account to the extent that that exists.

Emily Farrell: So, asset allocation but also asset location, right?

Daniel Wallick: Right.

Emily Farrell: And we have some materials as well on that too.

Daniel Wallick: Correct.

Emily Farrell: So, believe it or not, we’re actually close to out of time. So before I send off and send our audience home to bed or a glass of wine, which I can’t indulge in right now, any final thoughts, Hugh?

Hugh Watters: Well, I think, as we’ve alluded to, that both can play a role in the portfolio, and, hopefully, we’ve alluded to some of the framework or some of the questions that you need to ask yourself to understand is there a role for both active and passive within my overall portfolio? So I think it’s just, hopefully, we’ve shed some light so people can be a little bit more intelligent on that asset allocation decision.

Emily Farrell: Right, absolutely. Daniel?

Daniel Wallick: So I’d just like to say when Vanguard thinks about its investment philosophy, there’s four components to that. It’s know your goals as an investor, think of a balanced portfolio, acquire that at low cost, and be disciplined. You’ll notice the word indexing is not a part of that.

Emily Farrell: Yes, and that’s a surprise from Vanguard.

Daniel Wallick: But what matters here is cost. So really delivering at low cost. And Vanguard active is actually incredibly low-cost. It’s about 37 basis points. That’s cheaper than 99% of our competitors and 73% of the indexes that are out there. So although some people sometimes use the shorthand of active is more expensive than indexing, it’s actually not always the case.

But we do think cost is something for everybody to be cognizant of.*

Douglas Grim and Daniel W. Wallick. 2017. The role of active management in portfolio construction. Valley Forge, Pa: The Vanguard Group.
Brian R. Wimmer, CFA and Daniel W. Wallick. 2013. Analyzing multi-manger funds: Does management structure affect performance? Valley Forge, Pa: The Vanguard Group.

Emily Farrell: All right, so there’s a couple key takeaways for me. So I’ve got sumo, baby. Can’t forget that. Actually, I would probably want to forget it at this point. It’s quite the visual. Cost, obviously. I mean we can’t get away from it, and you’ll never hear us get away from it. So the time, willingness, and inclination in terms of making your own investment decisions. And, of course, the patience piece and the risk tolerance.

So, well, thank you so much. This was really helpful. I know I always learn a lot when I get to talk to you guys. Thank you all so much for spending some time with us tonight.

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