So last Monday (August 24) when all hell broke loose in the markets, active funds actually had a good day relative to their Vanguard index fund benchmarks (Exhibit 1). For more on methodology and the idea behind this analysis see my last post. Among all categories, 63% beat their corresponding index fund with only Small Value coming in below 50% (48% of Small Value funds did better than Vanguard Small Cap Value Index Inv). Small Growth funds had the best showing with 71% of funds outperforming. As you can see from the second panel in the chart, all of the categories had a miserable day (it’s a heat map to show relative performance). In general, the categories the dropped the most exhibited better rankings by active funds.
Exhibit 1 – Vanguard Index Funds Rank in Category by Morningstar Stylebox for Aug 24
So what is behind this “victory”. There is a lot of research out there showing that for active funds to do better than their benchmarks three things have to outperform: small cap, international stocks and cash. Here is a good summary from Josh Brown, or a more detailed research from GMO if you are so inclined. So what did we see on Monday (Exhibit 2)? Sure enough, all three of the preconditions are there.
Exhibit 2 – Relative Performance of Asset Classes for Aug 24
Another important point is fund expenses. The main reason active funds chronically underperform index funds is much higher expense ratios. However, it takes a longer time (a year or more) to fully manifest in NAV performance and fund rankings. Let’s say an active Large Blend fund charges 100 bps (1%) and Vanguard S&P 500 ETF charges 5 bps. Well over one year (or three, or five) the 95 bps differential really adds up. But for a one day ranking, 1/365th of 95 bps is a quarter basis point which is less than the NAV rounding threshold.
And since last week was kind enough (?) to provide us with back-to-back examples of really bad and really good days, let’s see what happened in Wednesday’s rebound (Exhibit 3). Naturally, active managers got trounced by Vanguard funds. Note that active managers “lost ” by a higher 73% margin than when they “won” by 63%. And as you might suspect, our three preconditions were perfectly aligned again (and with a great impact).
Exhibit 3 – Vanguard Index Funds Rank in Category by Morningstar Stylebox for Aug 26
Exhibit 4 – Relative Performance of Asset Classes for Aug 26
Active funds will have good days (and quarters and years, and maybe even a 3-year period here and there). But over time their higher expense ratios make it tough to keep pace with much cheaper index funds. Oh yeah, and rest assured that longer-term rankings as of August 28 are still in favor of index funds (by a lot).