New Vanguard Study Says You Can Beat The Market But Doesn’t Say How
Unbeknownst to many non-Finance nerds, Vanguard runs plenty of actively-managed funds in addition to its renowned line-up of index funds. Indeed, some of these Vanguard funds (Such as the Windsor and Wellington Funds) are perhaps just as famous as its 500 index fund. This implies two things to me: a.) Vanguard as an institution still places at least a little faith in the science/art of active portfolio management and b.) Vanguard probably expends a lot of effort on researching active strategies.
So it is.
A Breakthrough Study!
In a new study (opens as a pdf), Vanguard definitively answers the question we already knew the answer to: yes, sometimes if you are really, really good and lucky you can beat the market! Okay, that’s not exactly what the study says and it contains a few worthwhile insights. Let’s break it down.
Core And Explore Explained
Vanguard’s point revolves around the old core-and-explore theory of portfolio management. Traditionally, this has meant you should index within asset classes characterized by a very efficient market (large-cap U.S. and developed market stocks, for instance) and opt for active management in “less efficient” market segments (such as emerging markets, micro caps, etc).
Vanguard’s Take On Core And Explore
Vanguard turns this logic on its head, noting the data shows that indexing works very well in all market segments regardless of their reputed “efficiency.” Since the data clearly supports the notion that indexing is just as effective in, say, emerging markets as in the domestic market, indiscriminately opting for active management in for the developing market portion of your portfolio is unlikely to pay off. Rather, Vanguard’s approach is to focus on identifying talented and low-cost managers regardless of the part of the market they work in. That is, a talented manager in the large-cap U.S. stock space probably has a better chance of beating his benchmark than a below-average manager in the emerging market small-cap segment.
Making extensive use of back-testing, Vanguard’s findings lead some credence to their theory. Academics have long known that active managers do, on average, provide value through their stock-picking services. The kicker is that they don’t provide enough value to overcome the prices they charge! Put another way, the average stock-picker does seem to exhibit some small amount of skill. Unfortunately, the rewards will go directly into the skilled manager’s pocket and not to investors. This actually makes a lot of sense when you think about it. In an efficient market, the rewards of any endeavor are likely to go to the person who possesses this rare and special skill (talented stock picker) rather than to those who lack any special skills (mutual fund investors). Finding stock pickers who are both talented and who fail to charge a fee commensurate with their abilities is extremely difficult. Still, they do exist according to the research published by Vanguard.
But How Do You Find Skilled Managers?
Vanguard does give us a hint-a very important hint, in fact. If you want to increase your odds of beating the market, you’re more likely to find skilled stock pickers amongst the lowest-cost managers on the market and not the highest. This follows intuitively if you realize, as we do above, that stock pickers on average do out-perform the market slightly before accounting to fees. Since management skill is so difficult to come by, if your goal is to beat the market it makes much more sense to cut expenses rather than push for yet more skilled managers (which may not even exist!).
So far so good. We know that, all else being equal, we should look for skill amongst low-cost managers. But that’s not really enough information to consistently pick a winning mutual fund. Low costs will certainly increase your odds, but will they be enough to tip the scales in your favor? Probably not, especially not if the manager is “cheap for a reason,” so to speak. You’ve got to find a way to determine which of the cheap managers is undervalued and which are just bad. Unfortunately, Vanguard doesn’t provide us with any guidance here, making the study in-actionable mostly worthless. I suppose you could use past performance to try to identify which managers are likely to out-perform going forward, but a veritable mountain of evidence convinces us that’s a losing strategy.
So what’s the deal, Vanguard? Are you going to give us the recipe for your secret sauce or not? I’ll pay good money for it. Until then, I’ll continue to stick with index funds.