The Vanguard Group is well known for its index funds, whose low expenses lure bargain hunters, but the firm also offers a lineup of attractively priced active funds, all managed by carefully selected subadvisers.
It turns out that many of the virtues of index funds can work to similar advantage in the actively managed realm. Topping the list is low cost, which is key for any manager hoping to beat an index and the competition. Managers of funds with hefty expenses have to work that much harder to produce head-turning performance. Reasonable fees give Vanguard's managers an important leg up.
"We refer to their actively managed funds as their secret weapon," said Daniel P. Wiener, chairman of Adviser Investment Management, an independent money-management firm with more than $750 million dollars under management. "Most of the advantages they promote about their indexing accrues to their active funds just as well. And Vanguard has hired a lot of good managers."
Before fund managers can even begin to make shareholders happy, they have to match or beat the returns of whichever index their performance is being compared with and make up for annual expenses, often at least 1 percent, not to mention sales loads, 12b-1 fees and other operating costs.
By setting low expense hurdles, Vanguard has increased the chances its active funds will surpass their indexes and has set their managers up for success, said Sonya Morris, an analyst at Morningstar Inc. who follows Vanguard funds. This gives Vanguard's actively managed funds "a built-in advantage" over the competition, she said.
"Vanguard is a good place to look if you're looking for an actively managed fund," Morris said. "They're pretty good at ferreting out talented managers, and if you combine that with a very low expense ratio, that's a potent combination."
Of the firm's 130 funds, 63 are actively managed. Vanguard has outsourced the management of 38 of these funds to 26 institutional subadvisers, all chosen by its portfolio review group. When searching for subadvisers, Vanguard looks for qualities any investor would be wise to seek in a fund manager: experienced management teams with stable histories, long tenures and disciplined investment strategies.
"In a way, they've done a lot of the footwork for investors," Morris said. "They like managers with an articulated process that they'll stick with even when times are tough."
Vanguard's subadvisers are not necessarily household names, though folks in the investment world know them well, and individual investors may be familiar with the Vanguard funds they manage. Wellington Management Co. is one of Vanguard's main subadvisers; others include Barrow, Hanley, Mewhinney & Strauss and PRIMECAP Management Co. Among other things, the use of subadvisers allows Vanguard to deal more efficiently with asset growth; some funds have multiple managers, with assets divvied up among five or six people.
There is some added risk in using actively managed funds because you are relying on the performance of a manager, but index funds carry risks as well, said Wiener. Investors who relied on the Standard & Poor's 500-stock index through the tech bubble suffered huge losses -- though in many cases, that was far less than the losses suffered by some active funds.
"All through the '90s, in particular the latter half, the message was 'Buy an index fund, buy the 500, buy the total stock market, and you'll be safe, you'll be well diversified, you'll get the market returns.' And you know what those people got? A 45 percent loss in the bear market. I don't call that safe," Wiener said. "I would argue that low-cost active funds, whether at Vanguard or Fidelity or any other low-cost provider, are legitimate competitors to a low-cost index fund."
Actively managed funds at Vanguard come with higher expenses than the firm's index funds, which typically charge 0.25 percent or less. But the boost in performance is often worth the added expense, Wiener said. Because Vanguard rewards managers with performance bonuses, costs are sometimes higher because of stellar returns. This was the case with Vanguard Global Equity (VHGEX), one of the priciest funds at Vanguard, with an expense ratio of 0.86 percent.
"I'm willing to pay the extra expense if I'm getting good performance," Wiener said.
Standout active funds include the large-cap blend Vanguard PRIMECAP (VPMCX), which was recently closed to new investors. The Vanguard PRIMECAP Core (VPCCX), which employs a slightly different strategy, remains open, however. Vanguard Wellington (VWELX), a balanced fund that holds both stocks and bonds, has also accumulated a great track record.
When choosing between an actively managed offering and an index, take a close look at both expenses and performance. Vanguard Windsor II (VWNFX) is a large-value offering with a 0.35 percent expense ratio; it has returned 3.9 percent through October. That performance outpaces the 2.7 percent return of Vanguard Value Index (VIVAX), which is cheaper, with expenses of just 0.21 percent.
That may not seem like much of a boost, but research has shown that even seemingly small differences in annual rates of return can result in significantly higher total return over time.