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Can't Catch It

Chasing after the latest hot segment of the market or mutual fund is a lot like trying to drive a car forward while only looking at the rearview mirror. What has already passed does not tell you what lies ahead.

What follows is the transcript of a conversation between Vanguard's Akweli Parker and Brian Wimmer, a senior analyst in Vanguard's Investment Strategy Group: 

Akweli Parker: Okay, so Brian, let’s start by speaking to an important point raised your research paper, Quantifying the Impact of Chasing Fund Performance. The paper itself acknowledges that it’s a bit of a counterintuitive idea for investors to not want to move their money into actively managed funds that happen to be performing well for the moment at least.

So what can you say to them to convince them that in most cases, a buy-and-hold strategy can make the most sense for them for the long term?

Brian Wimmer: Yeah, well, you’re right, Akweli, it is counterintuitive. Investors tend to assume that if their performance is temporarily lagging, that they must be invested in a bad fund or a manager that isn’t talented, where in reality all actively managed funds—even those that are successful over long-term time periods—do experience some inconsistency in their performance from year to year.

Through research, what we do, what want to do is hopefully help to convincingly demonstrate to investors that performance chasing isn’t necessarily the favorable solution they might think it is. And our results in that area, as far as our research goes, have been quite compelling, in fact, more compelling than we thought going into the research. We found that a simple buy-and-hold approach outperformed a performance-chasing strategy by 2.8 percent per year on average during the ten-year period that we looked at. So it clearly can be in an investor’s best interest to invest for the long term.

Akweli Parker: That’s a really astounding number. So why do you think that despite all of this evidence—exposing the folly of chasing performance—that this behavior remains so embedded with investors?

Brian Wimmer: Well, first of all, I’d like to point out one thing to anyone who’s listening
who might have a tendency to chase performance is that you’re not alone. We see this
in the data. When we look at mutual fund cash flow data, we actually find that the recent strong performers in that space attract a disproportionate amount of the assets. So it’s very common. People get this feeling—this natural feeling—that they want to feel in control, right, particularly when it comes to the money that you’ve worked so hard for, that you’ve saved up over the years.

And there can also be a fear of missing out. When we see a headline in the media or potentially when you hear a story from a friend at a party about a fund that’s produced tremendously high returns over recent periods. And even though taking action to “fix”—and I’m using air quotes there—even though taking action to “fix” short-term underperformance by investing in a hot fund can feel like the right thing to do, what we found is that over time following some of those natural inclinations is actually hazardous to your wealth.

Akweli Parker: Wow. One thing I found pretty notable from the research was that this behavior of chasing performance, it’s not limited to retail investors. It appears that institutional investors engage in this behavior too; and, I don’t know, you would think perhaps that, given the access to better information that they have, or maybe just their greater sophistication as investors, that they would be immune to this. But, apparently, that’s not the case?

Brian Wimmer: No, it’s actually not at all. There is often that belief, though, that institutional investors are able to avoid those tendencies, but what we find in the data is that that’s not the case.

There’s been notable academic research that demonstrates this point, that investors of all kinds struggle to avoid performance chasing. In fact, over the years, I’ve personally talked with numerous institutional investors around the country who’ve told me directly that their active manager monitoring process, it revolves around three-year performance windows. And the underperformers are often put on watch lists after maybe a year or two of underperformance. And then after year three, they’re usually sold because of their underperformance over that shorter two- to three-year time period. And to nobody’s surprise, they’re actually replaced with performers that have done very well over the last three years.

So what this does is it inadvertently leads many investors to a performance-chasing strategy in which short-term underperformance trumps all and where those funds are sold and replaced by recent outperforming funds.

Akweli Parker: Wow, that explains quite a bit, and that seems like a good segue into one of the great debates of our time, at least in our industry, and that is this whole question of active versus passive management.

And we’ve actually seen some headlines recently about the really substantial asset flows going toward passive. The Wall Street Journal—I don’t know if you saw the recent article— but they went so far as to call this “a vote of no confidence” in active management.

So, first off, Brian, what do you think is driving this shift in investor sentiment, if, in fact, that’s what we’re seeing?

Brian Wimmer: Yeah, we have seen a shift. It’s been pretty clear in the industry. And while there are probably a number of reasons, there’s two that come to mind for me that I feel are probably the most primary reasons.

First is that, across the industry, index funds are often less expensive than active funds, sometimes significantly so. And this allows investors to keep more of the returns that they earn in those low-cost index funds.

Both Vanguard research and academic research has demonstrated that index funds outperform a majority of actively managed funds over long periods of time. And in recent years, that relationship has actually been even more pronounced than it has been in the past.

The second reason is, really, that index funds can provide consistent exposure to the markets that they track. It’s really the goal of an index fund, right? Therefore, there may not be a need for the same level of oversight, you’re not dealing with the same types of underperformance and outperformance versus a benchmark.

Active funds are a little bit different, right? They can sometimes significantly vary from the benchmarks that are stated in their prospectus.

Many investors appreciate the consistency of indexing, and along with that consistency, if it’s achieved with a low-cost fund, the potential for outperformance versus their
more expensive counterparts. As well as ease of use, right? There’s not as significant
a monitoring need.

But having said all that, this debate about active versus passive—for me, it’s not active versus passive. It’s active and passive. And we’re not saying that all actively managed funds are automatically inferior to their indexing counterparts. Active funds, if selected and used effectively, can also lead to successful investment outcomes.

Akweli Parker: Those are some really great points, and it leads me to a follow-up question. What role is there, then, for actively managed funds as part of investors’ portfolios?

Brian Wimmer: Yeah, well, as I mentioned, even though index funds can be wonderful options, they’re not the only option in a successful investment plan. Active and passive both have their merits. One interesting thing that I like to point out is that unknown to some investors, Vanguard does offer both—active and passive—and we’ve been successful with both. In fact, approximately 1 trillion dollars of the 3 trillion dollars that Vanguard manages, or about one-third of the assets under management that we have here at Vanguard, are in actively managed funds.

So we do believe that there is potential power in active management as long as you get a few key things right and you follow a few key success factors.

Akweli Parker: All right, so let’s talk about those.

Brian Wimmer: Yeah. So there’s three, and the first one is talent. Right, you have to identify talent. Investors must be willing to take the time and the resources necessary to do that due diligence in an attempt to find the talented managers, and this can be a challenging process and resource-intensive. And it’s mostly qualitative, not quantitative. There aren’t specific metrics that can guarantee you outperformance with an active manager, whether it’s a Sharpe ratio or a tracking error number. Looking at those things aren’t going to guarantee you future success.

But there is one thing, and this is number two for the success factors, that can help you out when you’re looking at active funds, and that’s expense ratio, in the form of lower-cost funds. So even in the active space, cost matters. Investors must be able to access that talent that they’re trying to get in an active manager at a low cost. So for every dollar paid for active management, the more you pay, the less you get to keep, and it creates a higher performance hurdle for those managers to outperform their benchmarks. So you need to keep your costs low.

And the third one is patience. Even the best active managers experience regular and sometimes extended periods of underperformance on their way to long-term success, if they are successful over the long term.

So if we think about those three things together, right, we have talented managers. You need to find those. That’s number one. You need to get them at a low cost. That’s number two. And then you need to remain patient with them through time, right, hanging on through those ups and downs. If you can do those things, getting active management and including it as a portion of your portfolio could be a worthwhile option.

Akweli Parker: Those are some really valuable points that you make, and especially the third one—it seems to be a recurring theme in a lot of what we talk about, which is the patience piece: “Don’t get rattled when you experience these periods of short-term underperformance, because it’s something that should just be expected. It’s really par for the course.”

Can you talk then, Brian, about some of the truly valid grounds for ending one’s relationship with an active manager?

Brian Wimmer: There are certainly some valid reasons; but what I’d like to point out is that they’re not necessarily purely performance-related, which is the first thing that people often think of. So, if for instance, there might be an ethical or a legal concern with
a manager or an investment firm. That would obviously be a situation in which a quick exit from a fund could be warranted. Another situation that would be cause for concern for us
or for any active investor is if a fund would deviate significantly and unexpectedly from its stated strategy and philosophy that it’s had in the past. That would be something to ask more questions about.

So while investors in general should be willing to hold on to those low-cost, disciplined active managers through all the market’s turbulence, we’re not advising that investors just simply stick their head in the sand. You need to dig deeper than performance alone. Understand what are the driving forces of underperformance and outperformance, and don’t be blinded by those short-term swings in the market.

Akweli Parker: Those are some really helpful insights. Do you have any other observations that you’d like to share?

Brian Wimmer: Yeah, I’d just reiterate, really, that patience is truly a virtue in the investing world, particularly for those investors who’ve chosen to use active management. Being patient, as we all know, is not easy all the time. But it is important, and investors who have stayed the course—and our research shows this—have avoided the temptation to chase performance, have demonstrated remarkably better portfolio returns over long periods of time.

Akweli Parker: Well, I think that’s a great point for us to close our discussion on chasing fund performance. Brian, it’s been a real pleasure.

Download Brian Wimmer's Research Note

© 2015 The Vanguard Group, Inc.  All rights reserved.  Used with permission.

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