They performed well--but not well enough.
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By John Rekenthaler | 01-11-17 | 06:00 AM | Email Article

Only the Good Die Young
It doesn’t seem fair. Thousands of actively managed U.S. equity funds trail the indexes over the long term, but survive. Meanwhile, over the next six weeks Vanguard will terminate two actively run stock funds that have outgained the indexes over the trailing three-, five-, and 10-year periods. The bad active funds continue to plague us, even as two good ones disappear quietly into the night. What justice is that?

John Rekenthaler is Vice President of Research for Morningstar.

In 2006, Vanguard launched Vanguard Structured Large-Cap Equity  and Vanguard Structured Broad Market . Well, not so much launched as converted. The two funds were private institutional trusts rather than public funds, governed by the Investment Act of 1940. So, Vanguard reorganized the duo, registering the two as conventional mutual funds. However, the new entities remained firmly institutional, demanding a $5 million minimum investment.

Most conversions into mutual funds should be regarded skeptically. Typically, the sponsoring company requests permission to show the fund’s pre-existing performance, which inevitably is terrific, because nobody comes to market with a losing fund. The question thus arises: How many failures occurred along the way? Was this one of five such funds attempted? 10? There is no way as a shareholder to know. But one thing that investors usually do learn, to their collective chagrin, is that the new fund’s public record fails to match its private success.

That problem did not occur with Vanguard’s Structured funds--because, I think, the company converted the two funds in response to client requests. True, Vanguard did show the funds’ pre-existing returns in some of its supplemental materials, but they were not aggressively promoted. Also, the company never offered the funds to retail buyers. That suggests that the funds’ track records could mostly be trusted; these funds were legitimate Vanguard offerings, as opposed to being incubator babies that surfaced only because they had performed particularly well.

Unlike with most active Vanguard funds, which are managed by outside subadvisors, the Structured funds have been run in-house. Vanguard has no desire to reinvent the traditional active-management wheel by assembling its own team of conventional researchers and portfolio managers, but it does have a quantitative staff. That makes sense given Vanguard’s brand--quantitative investment teams usually cost less than does traditional active research, and its output is often more transparent.

Less Activity, More Performance
Also fitting with the company’s profile have been the funds’ “structured” investment approaches.

Perhaps Jack Bogle’s greatest insight as fund-company chief was not the benefits of indexing, or even those of low costs, but instead the importance of avoiding surprises. Vanguard’s funds do what they are supposed to do. Period. They might lose a lot, if the markets in which they invest lose a lot, but informed shareholders always know why the funds behaved as they did. There are never mysteries to unravel.

In practice, that means holding large, diffuse portfolios rather than small, concentrated ones; carefully monitoring industry exposures; and ensuring that funds that state they invest in a given universe restrict themselves to such securities (in contrast with, for example, rival “blue-chip” funds that invest 15% of their assets in small companies). The Structured funds took such discipline one step further, maintaining such strict controls that they were, in effect, enhanced-index funds. In the past five calendar years, for example, Vanguard Structured Large-Cap Equity only once finished as far as 2 percentage points away from its benchmark, the S&P 500--that occurred in 2014 when it beat the index by 2.07 percentage points.

Such an approach flies in the face of today’s accepted wisdom, which is that active managers “can’t beat the indexes by being the indexes.” That is, rather than diversify broadly so that they minimize the effect of their decisions, portfolio managers should instead be bold. When they differ from an index, they should make that action meaningful. They should show high conviction. They should have a high Active Share.

So much for slogans. Over the trailing three- and five-year periods, Vanguard’s Structured funds have broken the alleged active-management rules and beaten their benchmarks by roughly 100 basis points per year, after expenses. (Of course, these being not only Vanguard funds but also Vanguard institutional funds, those expenses weren’t much.) Volatility has been modestly higher, too, but not so much as to erase the return advantage. For the full decade, the return advantage shrinks to about 40 basis points, but volatility also declines, to match the indexes’.

Those results, of course, do not qualify as a great triumph for active management; even with the power of compounding, a few dozen extra basis points per year won’t fix an underfunded institutional pension plan. However--and this is the beauty of low-ambition investment approaches--those results look to be sustainable. These funds weren’t propelled by one or two high-conviction wagers that landed in black rather than red; they succeeded by making thousands of calculations that, in aggregate, turned out to be more right than wrong. They stand a good chance of repeating that feat over the next decade.

Isn’t It Ironic?
If they weren’t liquidating, that is. Which brings us to the final item: Why the execution? As it turns out, a single institution owns most of the assets of both funds. Despite the funds’ successes, that institution decided to redeem its shares. It’s one thing to pay off a large shareholder who owns 1% of a fund; it’s quite another to locate the cash for a majority owner. Faced with that task, and no apparent buyers to supply the assets that the funds were losing, Vanguard opted to move on.

Oh, the ironies. The inventor of the index mutual fund runs actively managed funds that win in the investment arena--but lose in the marketplace because of a shortage of assets. The cautious investment strategy that posts a low Active Share beats the indexes, while so many idiosyncratic rivals fail. The allegedly fickle retail-fund investor proves to be the safer shareholder base than is the more-sophisticated institutional investor.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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