Vanguard's take on the active-passive debate
13 March 2019 | Portfolio construction
Matt Gierasimczuk (moderator): Todd, we often hear about the debate between actively managed investing and passively managed investing—the classic active versus passive debate. How does Vanguard feel about this? Is one better than the other, or is there room for both in a portfolio?
Todd Schlanger (Vanguard senior investment strategist): Sure. So with active and passive strategies, as you say, the way it's typically framed is a bit binary. So it's active or passive, as if there's not even overlap.
We've actually tested this, and we've looked at does the label active or passive tell us anything about future returns? We went in the Morningstar database where all the funds and ETFs are labeled, and we found actually no statistical significance in that label. You could have a very active strategy tracking an index and that would be labelled a passive strategy. You could have a very broadly diversified, active strategy and that would be labelled active even though it might be more similar to the experience you would get with a passive strategy. So the actual label active or passive doesn't tell us much.
If you look at what we can actually quantitatively identify and say it's associated with better returns, it's really just two things. It's the expense ratio of the fund that comes out of the return over time—it's very logical. Also, turnover. Because turnover is a good proxy for the trading costs that you can incur and those trading costs also come out of the return. So quantitatively, that's really all we can identify associated with better returns, not the label active or passive.
Matt Gierasimczuk: So the label active and passive is a bit of a misnomer. There's more to it than that.
Todd Schlanger: There's a lot more to it than that. When it comes to active, I would say there's really three things that you need. So low costs; whether you're using index or active, that always helps. It's associated with better returns. You also need to get talent at a low cost. So at Vanguard, we have a number of advantages in this area. Our ownership structure, the fact that we're typically working in large size, we build long-term relationships with skilled managers, so we think we are able to get very skilled managers at a low cost. So as an investor, you want to one, make sure you have access to a talented manager that has reasonable fees. But then there's a final element that's also very important, which is with indexing, there is what I would say is relative return predictability in how it's going to perform. And by that, I mean a broadly diversified index in that market returns are notoriously difficult to forecast, but with a broadly diversified passive fund, we know we're going to get that market return minus a small fee.
With active, and we've studied this, we look at just the best performing active strategy. So if you look at a 15-year period and you pull out just the best active managers that were able to outperform—it's about 20% of funds—they tend to underperform about half the time or more.
And so what that means is once you find that talented manager, you really have to be willing to be patient with them as their strategy goes in and out of favour. So there's an element of what we would call patience with that manager—or discipline—that you need. Also we think to be successful, that can be very specific to the investor—whether or not they have that real patience with the strategy. But if you're really following those core three ingredients, we think you can be successful with active. We also think you can be successful with passive.
Matt Gierasimczuk: That's great. Thanks for being here today, Todd.
Todd Schlanger: Thank you, Matt.
Recorded on October 11, 2018.
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