Vanguard Index Funds Lose Out To Their Own Stock-Picking Fund

According to conventional wisdom, picking individual stocks is a wasteful use of time and money. It suggests that attempting to beat market indexes leads to increased trading and tax costs. Hiring a mutual fund manager to select stocks also means paying substantial expenses. 

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As a result, most actively managed stock-picking funds underperform low-cost index funds, which passively track the entire index.

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However, economist Edward Tower, a professor at Duke University, presents an interesting research paper that challenges this argument. 

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Tower points out that even Vanguard, the pioneer of index funds, sometimes contradicts this rule with its mutual funds.

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For instance, Vanguard's Capital Opportunity mutual fund (VHCAX) has consistently outperformed its competing index fund for several years. This fund focuses on midcap growth stocks, which are typically faster-growing stocks with market values between $2 billion and $10 billion.

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Over the past 10 years, it has achieved a return of 226%, while Vanguard's low-cost index alternative, the Vanguard Midcap Growth ETF (VOT), has only reached 154%.

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Tower argues that such outperformance is not an isolated case. He states that when comparing active funds managed by Vanguard and Fidelity with their corresponding index funds, outperformance is the norm. Tower finds that diversified domestic active funds and even Vanguard's global, international, sector, and specialty funds tend to beat their indexed counterparts. Out of 16 Vanguard active funds analyzed, only five performed worse than their benchmarks.

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It is important to consider the measure of performance in this context. Tower's analysis focuses on risk-adjusted returns, known as "alpha". By comparing the monthly returns of each active fund to Vanguard's index funds, Tower determines the portfolio weight of the corresponding index fund that would duplicate the returns and management style of the active fund.

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This form of outperformance may not align with expectations. For example, Vanguard's Equity Income fund (VEIRX), classified as a large-cap value fund, exhibits a "positive" alpha, indicating that it has outperformed its index on a risk-adjusted basis. However, despite outperforming its benchmark, the fund's total returns over 10 years and five years are effectively the same as the low-cost Vanguard Value exchange-traded index fund (VTV).

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In essence, Tower's research serves as a reminder of two often overlooked investment principles. Firstly, the true advantage of index funds lies not only in their indexing approach but also in their low costs. 

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The actively managed Vanguard funds that have performed well typically have very low fees. For example, the Capital Opportunity fund charges only 0.43% annually for regular shares and 0.36% for "admiral" class shares, requiring a minimum investment of $50,000. Keeping costs low significantly improves the potential for active management to add value.

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Secondly, there is nothing inherently flawed with stock picking. Previous research has shown that when money managers have the freedom to invest solely in their highest-conviction stock picks, their chances of beating the market increase. 

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The underperformance of many active fund managers can be attributed to funds being driven more by marketing departments than investing departments. Fund companies often avoid deviating too much from their indexes, resulting in investors paying high fees for funds that closely track the index.

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It might be expected that more mutual funds would offer high-conviction investments at a low fee. However, Wall Street is a business, and overpriced, aggressively marketed, and mediocre mutual funds have generated significant revenues for a long time. This is why index funds have often been a sensible choice for investors.

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