Vanguard weighs in: Is active mutual fund management dead?

Vanguard chief William McNabb began 2017 with a bang. Looking at the 10-year-trend toward index fund investments, he said in his company’s latest quarterly report that people were now asking him whether active management of mutual funds is “dead.”

McNabb oversees one of the largest mutual fund empires in the world, so his opinion is important. But first, here’s a little background.

Actively managed funds -- for stocks, bonds and other investments -- are run by supposedly smart fund managers, aided by researchers, who make daily decisions on what to buy and sell. But their expertise comes at a cost: a layer of expense passed on to the client.

Conversely, passive funds simply track an index like the Standard & Poor’s 500, so buying and selling is easy and at a lower cost. Under founder and former CEO John Bogle, Vanguard was the first to realize this in 1975.

The race between index funds and actively managed accounts is akin to the classic contest between the tortoise and the hare. Over the short term, someone like former Fidelity Magellan (FMAGX) money manager Peter Lynch could put on a burst of speed and outpace the index. But Lynch is long retired, the Magellan fund has ceased to be a standout performer and, over the long haul, studies have shown that the market is likely to beat any money manager, no matter how smart.

But as economist John Maynard Keynes once said, “In the long run, we are all dead.” The question is: what is the long run?

McNabb took a 10-year look back at the struggles of active managers to keep up with his index funds and found them “subpar” and ‘disappointing.”

“Over the decade ended in 2015, 82 percent of actively managed stock funds and 81 percent of active bond funds have either underperformed their benchmarks or shut down,” McNabb said.

And investors know it too, he said. “Over the last three years investors have poured more than $1 trillion into index funds,” said McNabb, and they now account for nearly a third of all mutual fund assets.

But as the legal disclaimer found in every prospectus points out, “Past performance does not guarantee future results.” A January article in Barron’s magazine showed that active managers had their best performance in nearly a decade in 2016’s third quarter -- well after McNabb’s survey ended. Managed funds that had been hard hit in 2015 ended up in positive territory, with one up 99 percent over its peers.

Which brings us to McNabb’s other argument. Vanguard also has actively managed funds -- and lots of them. And there’s nothing wrong with them if they don’t charge too much.

The Vanguard CEO said the “biggest reason” that investors are leaving the so-called superstar managers is that the fees don’t justify the cost. For example, according to McNabb, active bond funds have an expense ratio that doubles the cost of an equivalent bond index fund.

“Active management can survive ... only if it’s offered at much lower expense. Otherwise active management is dead, and rightly so,” he claimed. “It has never been a winning proposition.”

But will cut-rate active fund managers appeal to investors? Even at punishing low levels (for Wall Street) it would be impossible to compete with huge index funds like Vanguard’s S&P 500 index fund, Vanguard 500 (VFIAX), which has an expense ratio of just 0.05 percent for one of its classes.

As the market improves -- and it rose more than 8 percent in the last quarter--  investors could decide that a percentage point or two in mutual fund expenses doesn’t mean that much. And once again, they could hitch their financial wagon to a superstar manager with a hot track record for the past few quarters.

Fees seem to matter most when returns are near zero or negative. Greed may now overwhelm caution, investors could converge into actively traded funds, and McNabb might be wrong after all.

The best strategy may be to hedge your bets and make active funds one-fifth of your portfolio. But it’s important to pick carefully, watching them closely and looking for fund managers who don’t charge too much.