Vanguard's Dan Newhall makes the case that with the right criteria, investors in actively managed funds can achieve higher returns than market benchmarks

Still, picking funds that outperform ahead of time and over the long run, isn't easy. That's because the chances of beating the market get cut by the cost of investing. Once expenses such as investment manager fees and trading costs are taken out, the odds of doing better tilt out of investors' favor; and holding onto excess gains gets harder over time.

Despite the challenge, Vanguard's long track record shows that it can be done. Dan Newhall, head of Oversight and Manager Selection, whose team is in charge of assessing Vanguard's active managers, cites three key factors that are crucial to long-term active manager success:

1. Invest with managers who have a clearly articulated and sensible philosophy,
2. Keep costs low, and
3. Maintain patience

Factor # 1: Focus on people rather than performance

If good performance is what you're looking for, where do you start? Not by filtering through historical performance, according to Newhall.

"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'm talking brilliant people—and disciplined processes that are followed faithfully, then you can ignore the noise. And you can certainly ignore one-year performance," he said.

Like location is to real estate, people are to active management—and it's not only about a star portfolio manager, as headlines may suggest. The entire engine that drives long-term performance matters when your destination is outperformance. It includes talented analysts, a sound investment philosophy, and robust procedures and risk management to help sustain performance.

There are no shortcuts to identifying top talent. For every fund manager Vanguard hires, Newhall's team conducts a rigorous, thorough, and long-term evaluation to distinguish whether performance was due to skill or simple luck. It doesn't stop there, once a manager is hired, a dedicated team maintains rigorous oversight to protect the interests of Vanguard's fund investors.

"The best managers have a clearly defined approach that gives them an edge versus the majority of other investors. We look for a track record of competitive results compared with benchmarks and peers, one that has been demonstrated in various investing environments, not just in either up markets or down markets," he said.

Factor #2: Minimize costs

Most investors are willing to pay for top performing funds, and most people assume the best managers command higher fees. But herein lies the paradox: paying a premium doesn't guarantee better performance, and Vanguard's research suggests the reverse could be true.

Of the drivers to long-term outperformance, low costs are one of the most persistent predictor of long-term active investing success. That's because the higher the cost, the higher the hurdle to outperformance. Once the costs of management fees and transactions fees are accounted for, any excess return, is scarce, underscoring how fragile outperformance can be. We believe sorting funds by cost is a good starting point for an active investment search.

Low cost

Some argue higher costs indicate more skilled management. Our results suggest otherwise. Low cost continues to be the quantitative filter proven to most effectively predict relative performance.¹

Percentage of actively managed equity funds that outperform their benchmarks, for periods ended December 31, 2015.²

Our analysis shows that the least expensive active funds have outperformed their benchmarks most consistently across the various time periods, as shown in the chart above.

Factor #3: Maintain patience

It's not enough to identify low-cost active funds that boast characteristics consistent with long-term outperformance. The third element is you.

"We, as investors, have to be patient with active management. No manager is going to give you outperformance every day or every week or every month. The key to capitalizing on that long-term outperformance is to stick with them through rough patches when the manager underperforms relative to the market," emphasized Newhall.

Patience

Many investors divest from a fund after three consecutive years of bad returns. But patience is necessary to collect on the performance successful funds. Of the 2,202 active equity funds in existence at the start of 2001, 476 outperformed. But 98% of those 468 outperforming funds, underperformed in at least 4 out of the 15 years ended December 31, 2015.⁵

Even the most successful funds can experience frequent or extended periods of underperformance. If you can't hold tight when times are bad, you won't reap active's potential rewards when times are good. Sometimes you won't, of course, but that's the risk you take with active.

Talent, cost, and patience are our active pillars

Between 1985 and 2014, Vanguard active funds, on an asset-weighted basis, have delivered about 0.45% in outperformance, net of fees.¹ That may seem insignificant, but a small return advantage compounded over 30 years, can amount to a meaningfully higher-ending portfolio value. In this instance, an initial $10,000 investment invested across Vanguard's active funds, on an asset-weighted basis, would have grown to more than $287,000 at the end of 2014. That's more than 60% above their stated benchmark return of about $175,500.

The power of compounding a small return advantage

The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors' shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at www.vanguard.com/performance. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Notes: Between 1985 and 2014, Vanguard active funds, on an asset-weighted basis, delivered about 0.45% in outperformance, net of fees, based on Vanguard's research detailed in Keys to improving the odds of active management success. This illustration depicts a hypothetical portfolio with a starting value of $10,000 that grows by 0.45% above the annual benchmark returns over the 30-year period. The portfolio balances shown are hypothetical. The final account balances do not reflect any taxes or penalties that might be due upon distribution.

The performance of each underlying Vanguard active fund was compared with its stated benchmark using monthly return data from January 1985 through December 2014, adjusted for 10 basis points of cost. Returns for all non-U.S., global, and domestic large-, mid-, and small-cap Vanguard active equity funds, including those that were merged or liquidated during the period, were included. The active equity portions of our balanced funds were excluded. In our calculations, the portfolios of Vanguard active equity funds were assumed to be rebalanced monthly to their target weights. Source: Vanguard.

We believe it takes three things working together—talent, cost, and patience—to achieve active management success. Understanding the keys to active success can help you choose well, remain patient during the inevitable downturns of even the best managers, and help you tilt the probability of long-term active success in your favor.

References

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

2. Data are as of December 31, 2015. Because of expenses, most index funds also underperform their benchmarks. Our analysis was based on expenses and fund returns for active equity funds available to U.S. investors at the start of each period. The oldest and lowest-cost share class was used to represent a fund when multiple share classes existed. Each fund's performance was compared with that of its prospectus benchmark. Funds that were merged or liquidated were considered underperformers for the purposes of this analysis. The following fund categories were included: small-cap value, small-cap growth, small-cap blend, mid-cap value, mid-cap growth, mid-cap blend, large-cap value, large-cap growth, and large-cap blend. Sources: Vanguard calculations, based on data from Morningstar, Inc.

3. Sources: Vanguard and Lipper, a Thomson Reuters Company. Data as of December 31, 2015.

4. Source: The average Vanguard fund expense ratio calculation is an equal-weighted average of all share classes. The average index fund and active fund expense ratio calculations are equal-weighted averages of all share classes of non-Vanguard index funds and active funds domiciled in the United States. (Vanguard calculations, based on data from Morningstar, Inc., data as of January 2016)

5. Data are as of December 31, 2015. Our analysis was based on expenses and fund returns for active equity funds available to U.S. investors at the start of the period. The oldest and lowest-cost share class was used to represent a fund when multiple share classes existed. Each fund's performance was compared with that of its prospectus benchmark. Funds that were merged or liquidated were considered underperformers for the purpose of this analysis. The following fund categories were included: small-cap value, small-cap growth, small-cap blend, mid-cap value, mid-cap growth, mid-cap blend, large-cap value, large-cap growth, and large-cap blend. Sources: Vanguard calculations, based on data from Morningstar, Inc.

Dan Newhall is a principal in the Vanguard Portfolio Review Department. This article was first posted on the Vanguard website. Treat the self-promotion aspects with caution. But the underlying message is interesting.