Among the stock market’s big winners in 2014, Vanguard stood tall.
That’s not all that remarkable, really: It has now been more than a decade since a mutual fund company other than Vanguard dominated the lists chronicling year-end asset inflows. What is astonishing, however, is the magnitude of the sums involved. Vanguard sucked in an eye-popping $233 billion over the course of last year, according to data from mutual fund research firm Morningstar. That’s higher than the original estimates, and far more than any mutual fund has attracted from investors in any year, ever.
The reasons behind Vanguard’s huge haul will matter to investors as they survey the market in 2015. That’s because the surge of money flowing into Vanguard represents a kind of capitulation, really.
As the S&P 500 index climbed to one record after another last year, the vast majority of mutual fund managers actively picking stocks to try to beat the market fared very, very poorly. Among the 1,417 large-cap growth managers that Morningstar tracks, only 171, or about 12 percent, managed to beat the 13.7 percent total return of the S&P 500 for the year.
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When active stock pickers are faring so poorly, it’s no wonder that investors gravitate to indexed investing instead — simply trying to track an index rather than actively looking to beat it. It’s cheaper, with fees counted in basis points rather than percentage points, and you know more or less what you’re going to get.
As of the end of November, the last period for which full data are available, Morningstar reported that those passively managed index funds had pulled in $156.1 billion in assets, as a group, over the prior 12 months, while their actively managed peers had lost $91.9 billion.
Vanguard is the dean of these passive managers, having launched the first major index mutual fund, an S&P 500 fund, back in 1975. It has parlayed its skill at indexing and its marketing prowess — as well as this first mover advantage — into an unchallengeable lead among index investors, commanding half or more of all indexed mutual fund assets. (Vanguard does also market actively managed funds, although it hires outside firms to tackle the day-to-day business of research and stockpicking.) Last year, its total assets under management topped $3 trillion, exceeding the size of the entire global hedge fund industry.
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For all its advantages, there’s a kind of annoying virtuousness to those who preach the undoubted benefits of indexing. Even Morningstar — which has built an entire business researching actively managed funds, awarding stars to the top managers — is on the verge of caving. “Do Active Funds Have a Future?” was the slightly plaintive title of an article penned by John Rekenthaler, Morningstar’s vice president of research, last summer. (The subtitle, just in case we were wondering: “The question is serious.”)
My own answer to that question: Yes, and no.
Here’s the dilemma that investors face. Indexes don’t always outperform actively managed funds. And even when they do, as they did so dramatically last year, there are always some actively managed funds that beat them. At the end of every quarter, I talk to a handful of those managers for The Wall Street Journal, and this year, both of the top performers argued that they believed the market seems likely to favor research and skilled stock picking over passive indexing going forward.
You can argue that it’s only logical that they’d say this — it’s what they do, after all. But they’ve also lived through periods that they know don’t favor stock picking, like the tremendous rally that began in March 2009, when the rising tide really did lift all boats. Similarly, you can argue that in 2013, when the price/earnings ratio for the S&P 500 soared 23 percent in a single year, gains came from multiple expansion rather than from company fundamentals. But Doug Roman, senior fund manager of the PNC Large Cap Growth Fund, argues that 2014 was different, with 80 percent of returns for S&P 500 companies coming from their earnings (and more specifically, the extent to which earnings delivered positive surprises) rather than from market-wide factors.
So, it’s entirely possible that stock-picking may make a comeback this year. And even if it doesn’t deliver across the board, there will always be that one fund out there, somewhere, that manages to do extraordinarily well, leaving the index funds in the dust. The problem, of course, is that it’s rarely the same fund two years running — or even two quarters in a row. Standard & Poor’s has found that less than 10 percent of mutual funds manage to stay in the top quartile for three years.
That’s the problem with pouring money into actively managed funds, and a big reason why studies have found investors tend to be much better off indexing over the long run. With thousands of actively managed funds out there, each run by an individual or a team with its own stylistic quirks and investment preferences, what are the odds that you’ll find yourself in the right place at the right time? And chasing mutual funds around is just as much of a bad idea as the idea of chasing stocks in pursuit of the one that’s going to do best in the next few weeks or few months.
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But if you’re going to join all the other investors in the indexing party, there are a few factors to bear in mind. Firstly, PNC’s Roman suggests that one reason that most active managers do badly is behavioral finance issues. “They just aren’t disciplined,” he says. When their strategy doesn’t work for a while, they get nervous, and gravitate to other factors. Roman’s own work at Vanguard reviewing outside managers taught him that you don’t have to be a genius to deliver consistently good and above-average returns, just disciplined and sensible. At PNC, he has applied those lessons to deliver above average returns — from stock picking — for his own investors.
If the idea of trying to pick out the skilled, disciplined manager from the rest of the horde intimidates you, remember that a single index doesn’t tell the whole story. John Bogle, Vanguard’s founder, may view the S&P 500 index as the ne plus ultra of indexing, but these days there are plenty of other indices, each of which offers you the chance to view the market in different ways: by sector, size, theme (green energy, anyone?) and region. Simply buying a single large-cap index fund might actually end up being an entirely new form of active investing: You’d just be making the decision to emphasize one part of the market over another using a passive mutual fund rather than a group of stocks, that’s all.
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