An Indexer’s Ode to Active

As the leader of Vanguard’s Equity Index Group, I spend each day with a team of passionate professionals who dedicate their careers to indexing. From my perspective, it’s nearly impossible to overstate the benefits indexing has created for millions of individual investors.

Indexing is well known for its low costs, which have sparked competition that’s driven fees down across the industry. Indexing’s broad diversification enables exposure to virtually every publicly traded stock and bond on the planet, available with just a few taps on a smartphone or clicks of a mouse. The simplicity and relative predictability of indexing helps investors understand their exposures and avoid some of the mistakes driven by underperformance.

Does that mean investors should consign active management to the dustbin of history? Not at all! Active management can play an important role in helping investors achieve their long-term investment goals. It might seem odd for the head of one of the world’s most prominent indexing shops to make the case for active investing, but it simply underscores the fact there isn’t any single best way to invest. It all comes down to an individual investor’s goals and circumstances.

Making the case for active

There are multiple factors that contribute to the success of active management. Here, I’ll discuss two particularly important ones. First, low costs. If an active strategy is going to have any chance of adding value over the long term, its alpha must exceed its expenses over time. Even the most talented active managers will fail to serve their investors well if they charge more in fees than they earn in outperformance for their clients. When evaluating active strategies, look for those that are committed to keeping costs low.

Second, an active strategy must be enduring and repeatable over the long term. The best active managers develop an investment process that may reliably add value over a full business cycle, time and again. Even the best active investors are unlikely to beat the market year after year in all market environments. But they have an investment process that, when applied consistently over the inevitable ups and downs of the market, can lead to outperformance over the long term.

For active to succeed, everyone must do their part

As my second key factor suggests, there will likely be times when an active strategy temporarily falls out of favor, when the markets move in a way that leads to underperformance for an extended period of time. Such moments can test even the most seasoned investors. This is where investors’ tolerance for active risk becomes salient.

Not much is certain in investing, but investors in active strategies should fully expect periods of underperformance, sometimes relatively long periods. For investors in active funds to achieve success over the long term, they must have the active risk tolerance to withstand these periods of underperformance. This is true not just for the end investors in the funds, but for the investment professionals and fund trustees who oversee the active managers. If active management is to succeed, patience is not just a virtue—it’s a requirement.

Active fixed income—a case study

One area where investors might consider active management is in fixed income. While the many benefits of indexing apply to fixed income as well, investing in bonds exposes investors to risks like interest rate, credit, and inflation risk. The fixed income universe is broad, with some 13,000-plus bonds in the broad-based Bloomberg U.S. Aggregate Bond Index. And that covers only the U.S. investment-grade market, with thousands more issues in high-yield, developed, and emerging markets bonds. And the universe is constantly changing. Unlike stocks, bonds typically have defined maturity dates, so older issues routinely mature and new issues continuously come to market.

On top of that complexity, many bonds are relatively illiquid and do not trade regularly, compared to stocks. This relatively low liquidity can create potential pricing inefficiencies and, therefore, opportunities for well informed investors. Changes in interest-rate and credit dynamics can also provide active investors with opportunities to add value. For example, if an active manager believes that the market is entering an extended period of interest rate changes, they can strategically manage their portfolio’s duration in an attempt to take advantage of upside opportunities, or to mitigate the risk of downside scenarios. Experienced active fixed income investors who develop repeatable investment processes and keep their costs low can add long-term value for investors.

Investors who want the chance to outperform the markets and have the appropriate risk tolerance should look for active managers that keep their costs low and have proven, repeatable investment processes.

Rodney Comegys
Global Head of Vanguard Equity Index Group

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