Considerations for active and passive

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1 Considerations for active and passive Brian J. Scott, CFA Senior Investment Analyst Vanguard Investment Strategy Group

2 Indexing s compelling value proposition Originally based on academic theory, which requires certain assumptions Efficient-market hypothesis (debatable) Investors can borrow and lend at the same interest rate (unrealistic) The layman s case for indexing Makes no assumptions about investors or market efficiency Relies on simple, provable mathematics 1. In aggregate, investors own every share of stock in the market 2. In aggregate, they must earn the market return before costs 3. If half outperform the market, the other half must underperform by an equal amount (zero sum) 4. After costs, investors, in aggregate, must earn less than the market 5. A majority of investors will underperform the market 6. Using a low-cost index fund/etf translates theory into practice 7. Note: This does allow that some investors may outperform But which ones? 2

3 The zero-sum game illustrated Distribution of investor returns Before cost Market benchmark Underperforming dollars Outperformin g dollars After cost Market benchmark Underperforming dollars Outperformin g dollars 3

4 The advantages of indexing Broad diversification Low costs Relative predictability History of long-term outperformance 4

5 Large blend Large growth Large value Mid blend Mid growth Mid value Small blend Small growth Small value Developed Emerging Global Short corporate Short government Intermediate corporate GNMA High-Yield The track record of active and passive portfolios has seemingly conformed to the zero-sum game 100% Most active funds underperform their benchmarks Percent of funds underperforming prospectus benchmark Leading to portfolios that can have lower returns and higher risk Relative performance for portfolios versus market 100% Ten-year return Ten-year std. dev. Resulting in a potential disadvantage versus low-cost passive Percent of active funds underperforming low-cost passive 100% 50% 40% 50% 0% -20% 0% Large blend Small blend Foreign large blend Emerging markets Intermediateterm bond -80% Median U.S. active equity portfolio Median U.S. active bond portfolio Median U.S. active non-u.s. equity portfolio There may be other material differences between products that must be considered prior to investing. Past performance is not a guarantee of future returns. Sources: Vanguard calculations using data from Morningstar, Inc. For the first chart, fund classifications and benchmarks provided by Morningstar. For the second chart, portfolio weights approximate the relative allocations in each market. Median U.S. active bond portfolio consists of two funds: 64% allocated to the median government fund and 36% allocated to the median corporate fund. Median U.S. active equity portfolio consists of three funds: 70% allocated to the median largecapitalization fund, 20% allocated to the median mid-cap fund, and 10% allocated to the median small-cap fund. Median non- U.S. active equity portfolio consists of two funds: 78% allocated to the median developed markets fund and 22% allocated to the median emerging markets fund. For the third chart, index funds are represented by those funds with expense ratios of 20 basis points or less. All performance numbers cover the ten years ended December 31, 2013, and include both surviving and dead funds. 5

6 Percentage of funds in each Percentage of funds in each Identifying skill is challenging: Past performance does not help... Subsequent five-year performance of funds originally ranked in: Top for the five years as of December 31, 2008 Bottom for the five years as of December 31, % 20% 15% 12.0% 11.9% 16.8% 20.7% 14.0% 50% 40% 30% 28.0% 46.9% 10% 8.6% 20% 16.3% 5% 10% 8.4% 7.3% 5.5% 0% Remained in top Fell to second Fell to third Fell to fourth Fell to bottom Liquidated/ merged 0% Rose to top Rose to second Rose to third Rose to fourth Remained in bottom Liquidated/ merged 6 2%: Chance of a manager starting in top 20% of all managers and remaining in top 20% over full ten-year period (20% x 12%) Sources: Vanguard and Morningstar. Notes: Past performance is not a guarantee of future results. Ranks all active U.S. equity funds covering the nine Morningstar style categories based on their excess returns relative to their stated benchmark during the five-year period as of For ease of presentation, we only show the results for the top and bottom of funds. There were 5,945 total funds, 1,205 of which fell into the top excess return as of 2008.

7 ... nor do industry rankings... Higher rankings have not led to outperformance Initial star ranking and subsequent excess returns versus benchmark +$51 Billion net cash flow 138 bps +$191 Billion net cash flow 125 bps $40 Billion net cash flow 102 bps $80 Billion net cash flow 74 bps $8 Billion net cash flow 1bps 7 Source: Vanguard, Vanguard s Principles for Investing Success, Notes: Past performance is not a guarantee of future results. Three-year excess returns and cumulative cash flows.

8 ... or new metrics such as active share Average excess return and tracking error for sample periods Active share decile Excess return Evaluation period Tracking error Percentage outperforming Excess return Performance period Tracking error Percentage outperforming 1 = High 5.39% 10.88% 81.11% 0.61% 8.28% 41.11% = Low High-Low 6.12% 7.34% 45.95% 0.62% 4.94% 24.63% T-Statistic Sources: Vanguard calculations, using data from Morningstar. Covers January 2001 through December Note: Past performance is not a guarantee of future results.

9 Percentage of funds The challenge of picking winners is exacerbated by lack of persistence (i.e., tracking error) Even successful funds experienced multiple periods of underperformance Distribution of the 275 successful funds by total calendar years of underperformance, % 25% 20% 15% 10% 5% 0% 97% underperformed in at least five years Sources: Vanguard calculations using data from Morningstar. Notes: Data and analysis cover the performance of U.S. active equity funds versus their appropriate style box benchmark. Active equity style benchmarks represented by the following indexes: Large blend Standard & Poor s 500 Index, 1/1998 through 11/2002, and MSCI US Prime Market Index thereafter; Large value S&P 500 Value Index, 1/1998 through 11/2002, and MSCI US Prime Market Value Index thereafter; Large growth S&P 500 Growth Index, 1/1998 through 11/2002, and MSCI US Prime Market Growth Index thereafter; Medium blend S&P MidCap 400 Index, 1/1998 through 11/2002, and MSCI US Mid Cap 450 Index thereafter; Medium value S&P MidCap 400 Value Index, 1/1998 through 11/2002, and MSCI US Mid Cap Value Index thereafter; Medium growth S&P MidCap 400 Growth Index, 1/1998 through 11/2002, and MSCI US Mid Cap Growth Index thereafter; Small blend S&P SmallCap 600 Index, 1/1998 through 11/2002, and MSCI US Small Cap 1750 Index thereafter; Small value S&P SmallCap 600 Value Index, 1/1998 through 11/2002, and MSCI US Small Cap Value Index thereafter; Small growth S&P SmallCap 600 Growth Index, 1/1998 through 11/2002, and MSCI US Small Cap Growth Index thereafter. Past performance is not a guarantee of future results. Number of individual calendar years of underperformance

10 Amount of excess return This is important because of the proclivity to move from fund to fund Institutional investment management hire/fire decision Before manager change 12 After manager change years 2 years 1 year 1 year 2 years 3 years 10 Source: Goyal, Amit, and Sunil Wahal, The Selection and Termination of Investment Management Firms by Plan Sponsors. (The Journal of Finance 63 (4): 1,841. Data: 8,775 hiring decisions by 3,417 plan sponsors delegating $627 billion in assets. 869 firing decisions by 482 plan sponsors withdrawing $105 billion in assets. Analysis covers 1996 through Note: Past performance is not a guarantee of future results.

11 10-year treasury yield (percentage) Even in environments where indexing has been declared to be the worst choice, results do not conform to expectations Percent of active bond managers that underperformed in recent rising-rate episodes % 69% % July 2010 January 2011 July 2011 January 2012 July 2012 January 2013 July 2013 Rising-rate period Yield at start Yield at end Rate increase in percentage points Median excess return Cumulative return of Barclays U.S. Aggregate Bond Index Active bond managers that underperformed their benchmarks 1 10/7/2010 2/8/ % 3.72% % 3.02% 39% 2 6/1/2012 7/12/ /1/2013 7/12/ Sources: Vanguard, based on fund returns from Morningstar, and index returns from Barclays. Note: Past performance is not a guarantee of future results.

12 Costs: A more reliable alpha? Lower costs can support higher returns Average annual return for ten years through % Large-cap Mid-cap Small-cap Short-term Interm-term 10% 8% 6% 4% 2% 0% Value Blend Growth Value Blend Growth Value Blend Growth Gov t. Bond Gov t. Bond HY Bond Median fund in lowest-cost quartile Median fund in highest-cost quartile 12 Sources: Vanguard, using data from Morningstar. Note: Past performance is not a guarantee of future results.

13 Lowering the cost of active can lead to advantages Our focus is on what we can control Low costs Talented managers Performance-based fees Long-term orientation Vanguard active equity and balanced funds One-year: June 30, 2014 Above peer group average Below peer group average Below benchmark Above benchmark 8% 72% 16 4 Ten-year: June 30, 2014 Above peer group average Below peer group average Below benchmark Above benchmark 36% 62% Sources: Vanguard and Lipper, a Thomson Reuters Company. Peer groups defined by Lipper. Notes: For the one-year period ended June 30, 2014, 17 of 22 balanced funds, and 37 of 46 active equity outperformed their Lipper averages. For the ten-year period ended June 30, 2014, 13 of 14 balanced funds, and 36 of 37 active equity funds outperformed their Lipper averages. Results will vary for other time periods. Only funds with a minimum one- or ten-year history, respectively, were included in the comparison. The competitive performance data shown represent past performance. Past performance is not a guarantee of future results.

14 Annualized expected alpha* Active should come with an expectation of outperformance, but how much should be in a portfolio given the track record? For those who desire the chance for outperformance, the allocation to active depends on the type of active used Larger allocation to active Smaller allocation to active None Active quantitative Structured equity Enhanced indexing Indexing Riskcontrolled active Diversified active Annualized projected tracking error volatility Specialty active 14 * Note: Realized alpha can be both positive and negative.

15 Excess return Tracking error, or deviations from a benchmark, can be a gauge for how much active Relationship between active share and average annualized excess returns January 1, 2006 December 31, % Smaller allocation to active 8% Larger allocation to active 4% 0% -4% -8% -12% 20% 30% 40% 50% 60% 70% 80% 90% 100% Active share Closet indexing Concentrated Diversified Factor bets 15 Sources: Vanguard calculations, using data from Morningstar. Notes: One portfolio plotted below the range of active share displayed. Past performance is not a guarantee of future results.

16 Adding passive to an active portfolio can shrink the distribution of performance around the market, reducing flight risk Risk of losing clients Benchmark/ market return Less risk of losing clients Benchmark/ market return Portfolio s periodic returns 16

17 Dead < to -9-9 to -8-8 to -7-7 to -6-6 to -5-5 to -4-4 to -3-3 to -2-2 to -1-1 to 0 0 to 1 1 to 2 2 to 3 3 to 4 4 to 5 5 to 6 6 to 7 7 to 8 8 to 9 9 to 10 >10 Dead < to -9-9 to -8-8 to -7-7 to -6-6 to -5-5 to -4-4 to -3-3 to -2-2 to -1-1 to 0 0 to 1 1 to 2 2 to 3 3 to 4 4 to 5 5 to 6 6 to 7 7 to 8 8 to 9 9 to 10 >10 Theory in practice Distribution of excess returns over five years ended 2013 for funds that ranked in top as of Same distribution: Adding 50% low-cost passive (10 bps haircut for passive exposure) funds 161 funds Annualized excess returns to stated benchmark Sources: Vanguard and Morningstar. Notes: The first figure includes all diversified U.S. equity funds that ranked in the top for the five years ended The second figure includes the same funds as the figure on the left, but it combines each fund with a passive index matching the fund s investment style in a 50/50 ratio. To reflect implementation expenses, the index returns are reduced by 10 bps annually. Excess returns are measured relative to a fund s stated benchmark. Data reflect excess returns over the period for the 1,205 funds in the top from 2004 through Annualized excess returns to stated benchmark

18 Conclusion Indexing can provide a simplified, efficient investment vehicle with the potential to increase shareholder wealth across a broad range of asset and sub-asset classes Index investments have generally and historically offered long-term outperformance relative to a majority of actively managed funds The higher costs of active management can provide index funds a head start in relative performance 18

19 Important information This information is intended for investors outside the United States and should not be provided to individual investors in the United States. The information contained herein does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. Broker-dealers, advisers and other intermediaries must determine whether their clients are eligible for investment in the products discussed herein. Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling. All investing is subject to risk, including possible loss of principal. The fund does not intend to establish a place of business or otherwise intend to conduct business in the Cayman Islands. Accordingly, the fund should not be subject to the supervision of any Cayman Islands authority The Vanguard Group, Inc. All rights reserved. 19

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