Why cost matters in the active vs. passive debate

Vanguard 1x1 pixelWhat a difference a few decades can make. When Vanguard launched the first index mutual fund for retail investors in 1976, we were ridiculed. Industry “experts” mocked the idea that investors would ever settle for performance that matches the performance of the market.

Fast-forward 20 years. In the mid ’90s, I can remember working in institutional sales for Vanguard. It was the early days of the tech boom, and it was my job to sell our investments and retirement services to Fortune 500 companies. I’d meet with clients to discuss our index funds, and, well, to call their interest lukewarm would be extremely generous.

Today, it’s a much different story. On behalf of their clients, advisors are pouring money into passively managed funds and fleeing high-priced actively managed funds en masse.

Investors: Cost matters

In recent years, we’ve seen some pretty dramatic evidence of people voting with their feet. From 2000 to 2015, more than $600 billion flowed into the lowest-expenses quartile of equity funds, while nearly $550 billion was drained from funds in the three most expensive quartiles.1

Those trends were driven primarily by advisors purchasing low-cost ETFs for their clients’ portfolios.

We’ve contributed to the trend by relentlessly focusing on reducing the cost of investing. Lower expenses allow fund shareholders to receive a greater share of a fund’s returns. From the end of 2016 through mid-May, reductions in our expense ratios saved investors an estimated $337 million.

Source: Vanguard.

* The estimated cumulative figure for all share classes from December 2016 through May 2017 for the funds that have updated their expense ratios. Estimated savings is the difference between prior and current expense ratios multiplied by average assets under management (AUM). Average AUM is based on a fund’s average assets during a month, which are then averaged over the fund’s fiscal year.

Costs, costs, and costs

Despite a seismic shift out of actively managed investments and into index funds, the whole active versus passive debate misses the point. The simple fact is, investors can succeed using both actively and passively managed funds.

At the end of the day, your clients’ long-term investment success will rise or fall largely as a result of one piece of your investment strategy: costs. In an era in which returns are expected to fall short of their historical averages, costs have never been more important. Our research has shown that what investors pay for the investments they own, whether they be active or passive, can affect their net returns more than anything else.2

A low-cost actively managed fund can be an effective element of a well-balanced, diversified portfolio. As an advisor, you understand this better than anyone as you seek to make your clients’ portfolios more cost-efficient.

Our own balance sheet proves this point. In 2016, investors added $20.4 billion to our low-cost actively managed funds, according to Morningstar data. That’s in stark contrast to the rest of the industry, which had $340.1 billion in outflows from actively managed funds.

At Vanguard, we work with some incredibly talented active managers, but their real performance advantage is they aren’t handicapped by high expense ratios. In 2016, our average asset-weighted expense ratio for all actively managed funds was 0.20%, compared with the industry average of 0.71%.1

Giving credit where it’s due

Industry observers like to give us credit for forcing our competitors to lower their costs so they can remain competitive. They call it The Vanguard Effect™.

I think that’s only part of the story, though. I say much of the credit goes to you: As advisors, you’re the gatekeepers for what investments go into your clients’ portfolios. Your emphasis on cost has been the primary driver in lowering the total cost of investing.

So continue to be vigilant in demanding low costs from investment companies. Your clients deserve it.

1 Morningstar, Inc., data as of December 31, 2016.

2 Vanguard, 2014. Vanguard’s Principles for Investing Success. Valley Forge, Pa.: The Vanguard Group.

Editor's Note:
This post was updated to reflect expense ratio changes as of April 28, 2017.

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Tom Rampulla

Thomas M. Rampulla is head of U.S. Financial Intermediaries and managing director of the Vanguard Financial Advisor Services™ division. He is responsible for business unit strategy and oversees business development, relationship management, and daily operations for more than 1,000 financial advisor firms who entrust more than $1 trillion in assets to Vanguard. Mr. Rampulla joined the company in 1988. Before his current role, he was responsible for the management of Vanguard's European business and was a senior member of Vanguard's International Management Team. Additional roles include management of the distribution of Vanguard ETFs® and mutual funds through Vanguard's financial advisor partners, portfolio management in Vanguard's Fixed Income Group's Stable Value Management division, and various positions of increasing responsibility in Vanguard's Financial division, Institutional Sales, and Marketing. Prior to joining Vanguard, Mr. Rampulla worked for the financial software firm Shaw Data Services. He earned his B.S. from Bloomsburg University, obtained his M.B.A. from Drexel University, and is a graduate of Harvard Business School's Advanced Management Program.

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