A look at Vanguard's approach to active management
Vanguard pioneered index funds for individual investors, but actively managed funds represent a significant portion of our business. In this article, Dan Newhall, head of manager oversight for Vanguard Portfolio Review Department, answers questions on our unique approach to active management as well as our rigorous active manager selection process.
How is Vanguard's approach to active management different from that of other investment managers?
With active management accounting for 44% of our $1.7 trillion in assets under management, Vanguard is a major player in the active management space. I think there are four primary ways we distinguish ourselves from our competitors.
First, Vanguard employs in-house teams of investment professionals to manage those active portfolios that we believe we can run as well as anyone else we might consider hiring, and at a very low cost. This is the case for all of our money markets, most of our fixed income, and a majority of our quantitatively managed equity funds.
Second, we go outside Vanguard through our partnerships with external investment firms. We have partnered with 29 independent firms employing 48 teams of professionals with hundreds of supporting analysts. These firms manage the 76 portfolios that we believe would benefit from their specialized expertise. The majority of our actively managed equity funds are managed this way.
We think partnering with many of the world's premier investment management firms has been very beneficial for shareholders because it allows us to broaden the opportunity set from what we might develop in-house. By going to the outside, we are able to draw on the diverse talents and investment philosophies of these managers.
Another benefit of partnering with external firms is that it helps us retain our objectivity and independence in terms of searching for, negotiating with, and retaining managers.
The third thing that differentiates Vanguard is our multimanager approach to active management. We have been running multimanager funds since Windsor™ II in 1987, but we have increased the number of funds that are multimanaged, primarily because we think it's better for most investors. You diversify single-manager risk and by combining talented, high-conviction managers together, you preserve the excess returns and reduce the natural volatility of any one manager.
And the final big benefit to active management at Vanguard is our at-cost structure and scale, which allows us to negotiate very favorable fees on behalf of shareholders relative to our competitors. The cost of Vanguard's active funds, on average, is less than one quarter of the average cost of the industry's active funds (Source: Lipper Inc., as of December 31, 2010).* This provides an advantage, because shareholders get to keep more of their returns.
*Vanguard's average annual expenses for actively managed funds are 0.29%, compared with the industry average of 1.18%.
Please describe your process for selecting active money managers. Do you focus on quantitative or qualitative characteristics or a combination of both?
Our manager selection framework is really based on qualitative analysis, but is supported by quantitative analysis, so we don't make assumptions that aren't supported by the facts. We consider quantitative measures to assess factors such as long-term performance, risk measures, style consistency, and security selection. But our decisions about a manager's fitness often come down to qualitative issues such as the experience of the investment team as well as a firm's research, compliance, and trading capabilities.
To be successful, we leverage the depth of our team and Vanguard's expertise in this area, which dates back to our beginnings more than 35 years ago.
We employ a team of 25 people in the Portfolio Review Department dedicated to this process. The responsibility of our senior analysts is to know every manager in their respective search categories and to have an overall view of each manager's capabilities.
When a specific need arises for one of our funds, we zero in on two or three highly rated firms that meet the specific criteria for that search. If we are looking for a large-cap growth manager, for example, who has a fundamental investment approach with a concentrated portfolio, low turnover, and any number of other characteristics, then you can see how this would narrow down our search considerably.
After we determine that a manager is an appropriate choice for a particular mandate and both Vanguard and the manager's firm have agreed to a partnership, our rigorous, multi-level oversight process ensures adherence to the style defined by the mandates of our funds. Vanguard Portfolio Review Department is responsible for the oversight and evaluation of all Vanguard's funds and managers. In addition to the day-to-day oversight that we provide, a committee of senior Vanguard management and the board of directors meets regularly with our fund managers and has the ultimate decision-making authority.
So we really use a rigorous vetting process to select outside managers.
What criteria does Vanguard use to determine the most appropriate benchmark to evaluate the performance of one of its actively managed funds?
The simple answer is we select the benchmark that is most appropriate for the objective of the fund and the manager. So if it's a large cap manager, for example, it should at least be a large cap benchmark. When it comes to a style benchmark, it gets a little more complicated.
In the case of a large-cap growth fund like the Vanguard PRIMECAP Fund, for example, it is clearly a large cap with an emphasis on growth, but its managers are not afraid to buy a stock that you'd find in a value benchmark. And the fund's managers are very traditional in their desire to beat the broad market. They think that if they can outperform the broad market over time, they'll beat their peers and most likely the growth benchmark.
Now things have evolved and increasingly managers are more style specific. So the managers we've hired for two of our other large cap growth funds, Vanguard U.S. Growth and Vanguard Morgan™ Growth, are more style-specific.
But the difference between U.S. Growth and Morgan Growth is that U.S. Growth is more of a pure large cap fund and so the Russell 1000 Growth, which is a larger cap index, is an appropriate benchmark. With about a third of its assets in mid-cap stocks, Morgan Growth is more of an all-cap fund, and we compare its performance to the Russell 3000 Growth Index.
There's definitely overlap but it does suggest appropriately that we're encouraging the managers to think beyond just the largest companies, and in the case of Morgan Growth, we actually employ two mid-cap growth managers to ensure we have that all-cap nature.
So benchmarks are something we select carefully in consultation with the managers. This is part of our fund design process.
If Vanguard's research shows that, over the long term, index funds outperform the vast majority of actively managed funds, and index funds often have an inherent advantage because of their lower costs, why should long-term institutional investors include actively managed funds in their portfolios at all?
Well, they don't have to. Certainly, we believe in all of the merits of indexing, and indexing is a great way to capture the return of the market at a very low cost. Indexing has historically outperformed the majority of active managers after costs are included because the market is a zero-sum game before costs, but once you add in the costs of active management, the average manager will underperform.
But we also believe that Vanguard is able to find above-average active managers who can outperform the market over the long term. While nothing is perfect, we employ a lot of resources and go out and find these firms with the kinds of qualities and characteristics that can give them a very good chance of outperforming. We put a lot of energy into finding these firms, securing their talents, negotiating a very fair fee, and continuing to monitor them. To the extent you wish to pursue active management and have the chance to outperform the market, we think Vanguard's approach to active management makes a great deal of sense.
Given your multimanager approach, how do you monitor and evaluate a fund's performance over certain time periods? Can you discuss the role that investment style and other fund attribution factors play in determining performance over different time frames?
We look at performance a number of ways. We look at both short- and long-term performance with an emphasis on long-term performance because short-term performance results can be very volatile and misleading. You simply can't draw any valid conclusions about a manager's skill or ability to add value over a period shorter than three years.
So we really focus on longer periods of time and rolling periods of time, because again point to point a manager can look awful or brilliant and that's just an appearance. It may not be the reality. But if you would look at longer periods of rolling performance, you get a better sense for a manager's results, and you want to look at it relative to an appropriate peer group and maybe a broad market benchmark and a style benchmark if that's appropriate.
As far as what we focus on in particular, it would depend on the manager. For managers who specialize in stock picking, then from an attribution standpoint, you really want to assess their stock-picking skills. If it's being driven by country-level decisions, you want to assess how often they are correct about their outlook for the country and whether they profitably capture that opportunity.
So in terms of the attribution, it's important to figure out your expectations for that manager. For most of our managers, it's primarily stock selection that we're evaluating. Do they know their companies really well, do they have an understanding of the drivers of performance, and does that performance play out as expected? That's what you look for in the attribution.
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