Vanguard: The hidden $1.3 trillion player in active management

While the Vanguard Group is best known for being a pioneer of index mutual funds and exchange-traded funds, it also happens to be one of the world’s largest practitioners of active management. In a presentation Tuesday in Toronto that is taking place across the country, Vanguard executives said the US$5 trillion of money it manages worldwide includes $1.3 trillion in active management.

Vanguard Investment Strategy Group’s Head of Multi-Asset Portfolios, Daniel W. Wallick, presented financial advisors with a framework for constructing portfolios that combine active and passive approaches to investing. The heart of Vanguard’s approach remains broad cap-weighted indexes (or so-called Beta), which is what Vanguard says it means when it uses the term “indexing.”

For many investors, the broad diversification, low costs and tax efficiency of its mainstream index funds and ETFs may suffice.

But, depending on the desired complexity, Vanguard can incorporate “factors” like momentum, value, or liquidity, all factors that have shown a persistency for generating alpha (outperformance) over long periods of time. Beta and Tilts (to for example, overweighting the home country or large market caps) can be combined for the single most important task of Strategic Asset Allocation but overlaying this can be the addition of potential “Alpha” sources like Security Selection and Timing.

“Strategic asset allocation through market-cap-weighted indexes makes for a powerful tool,” Wallick said. And over 10-year periods, asset allocation policy continues to be the biggest source of variations in returns. Asset allocation explains 86% of return variation in 303 Canadian balanced funds tracked by Vanguard, 91.1% of 709 balanced funds in the U.S., 80.5% of 743 balanced funds in the UK and 89.1% of 580 balanced funds in Australia.

Cost trumps talent, patience is crucial

Vanguard sees three keys to successful active management: Cost, Talent and Patience. Wallick described the in-depth process Vanguard uses to select subadvisors for its actively managed funds but hiring talent has to be within strict cost-control parameters.

“Cost is a powerful indicator of future alpha.” But once the talent has been identified and hired, patience is required: Vanguard research over 15 years found that of 2,200 initial funds, 22% survived and outperformed, 24% survived but underperformed, and 54% did not survive. But even among the 22% that survived and performed, 98% of them underperformed in at least four years.

By focusing on both low costs and rigorously overseeing actively managed subadvisors, Vanguard multi manager funds have outperformed their Lipper peer-group averages by various percentages: 78% of them over 1 year, 83% of them over 3 years, 76% of them over 5 years and a whopping 100% over 10 years.

Factor-based funds vs traditional active funds

There is a half-way position between traditional beta-based Style index funds and ETFs and traditional active funds. The former (Beta) provide low cost, low turnover and lower tracking error while traditional active funds provide the opportunity to add alpha, albeit at a higher cost, potentially greater volatility, and less transparency and control. Between these are factor-based funds and ETFs, which provide consistent targeted exposure as well as low cost, but may have higher tracking error and potentially higher turnover.

Various variables drive the active-passive decision: gross excess returns expectations, cost drag (including taxes), level of active risk (Volatility) and Active risk tolerance of the investor: their comfort with the possibility of being wrong.

But the starting point for all investors will always be simple indexing (Beta). For those who prefer simplicity that may be sufficient, but for clients or advisors willing to go further in accepting a little more risk for potential higher returns, the kind of active management approaches outlined can be considered.

The formal presentation by Wallick was followed by a panel discussion and opened up for questions from the (mostly) financial advisors in the audience. I was myself curious about how the three popular Vanguard Asset Allocation ETFs announced early in 2018 (VGRO, VBAL, VCNS) can be integrated with the various other active strategies described in the presentation. I was told there are significant differences between, for example, VBAL (the asset allocation ETF that is 60% stocks to 40% fixed income) and the Vanguard Global Balanced Fund. The VBAL ETF includes more than 20,000 securities (stocks and fixed income) around the world, while the (actively managed) Global Balanced Fund is more concentrated: it holds just 83 equities and 350 fixed-income investments.

According to a brochure available at the event — An actively different way to invest — the Vanguard Global Balanced Fund is managed by sub advisor Wellington Management Canadian ULC but with separate equity and fixed income teams. The asset mix is 65% equities to 35% fixed income. The management fee for series F is a maximum 0.5%, which is roughly double the 0.22% of VBAL.

The Toronto presentation was preceded in the past week by similar events in Montreal and Burlington, and winds up this Thursday in Vancouver.