The case for index fund investing

Transcription

1 The case for index fund investing November 18, 2015 Garrett L. Harbron, JD, MBA, CFA Vanguard Investment Strategy Group

2 Agenda Investing as a zero sum game Relevance to investors The record of active management Performance and survivorship bias Past performance is not a guarantee of future returns Comparing active to passive The role of cost Evaluating the record of low cost passive Other benefits of indexing 2

3 What is an index, indexing? A market index is group of securities representing a market benchmark Intended to tell investors what has happened in a particular market Provides a benchmark for performance Since market indexes are designed to reflect a market, they are constructed to be market cap weighted Non market-cap weighted portfolios will not reflect the average return of the dollars invested in that market May be considered a rules-based factor exposure Indexing permits low-cost participation in the performance of that market at all times 3

4 Investing as a zero sum game 4

5 Investing as a zero-sum game Underperforming funds Market benchmark Outperforming funds Costs High-cost investment Low-cost investment At any time, the holdings and investment processes of all investors aggregate to form a market If one investor s dollars outperform the market, another investor s dollars must underperform Investment costs shift the distribution to the left, leaving fewer dollars to the right of the market return 5

6 The record of active management 6

7 Performance and survivorship bias Percentage of active funds underperforming the average return of low-cost index funds 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Large Blend Small Blend Foreign Large Blend Emerging Markets Intermediate Term Bond Large Blend Small Blend Foreign Large Blend Emerging Markets Intermediate Term Bond Large Blend Small Blend Foreign Large Blend Emerging Markets Intermediate Term Bond Large Blend Small Blend Foreign Large Blend Emerging Markets Intermediate Term Bond Large Blend Small Blend Foreign Large Blend Emerging Markets Intermediate Term Bond 1-Year 3-Year 5-Year 10-Year 15-Year Based on funds surviving for full period Based on survivors plus funds closed or merged during period Notes: The actively managed funds are those listed in the respective Morningstar categories. Index funds are represented by those funds with expense ratios of 20 basis points or less as of December 31, Data reflects periods ended December 31, Sources: Vanguard and Morningstar, Inc.. 7

8 The risk that a fund liquidates or merges following poor performance must be accounted for Cumulative excess returns for liquidated/merged U.S. equity funds before the termination date 0.0% -0.5% -1.0% -1.5% -1.03% -2.0% -2.5% -3.0% -2.47% -3.5% -4.0% -4.5% -3.98% 6-months prior 12-months prior 18-months prior Note: Performance data reflect periods ending December 31, Sources: Vanguard calculations, using data from Morningstar, Inc. Equity benchmarks are represented by the following indexes Large blend: MSCI US Prime Market 750 Index through January 30, 2013, CRSP US Large Cap Index thereafter; Large growth: S&P 500/Barra Growth Index through May 16, 2003, MSCI US Prime Market Growth Index through April 16, 2013, CRSP US Large Cap Growth Index thereafter; Large value: S&P 500/Barra Value Index through May 16, 2003, MSCI US Prime Market Value Index through April 16, 2013, CRSP US Large Cap Value Index thereafter; Mid blend: S&P MidCap 400 Index through May 16, 2003, MSCI US Mid Cap 450 Index through January 30, 2013, CRSP US Mid Cap Index thereafter; Mid growth: MSCI US Mid Cap Growth Index through April 16, 2013, CRSP US Mid Cap Growth Index thereafter; Mid value: MSCI US Mid Cap Value Index through April 16, 2013, CRSP US Mid Cap Value Index thereafter; Small blend: Russell 2000 Index through May 16, 2003, MSCI US Small Cap 1750 Index through January 30, 2013, CRSP US Small Cap Index thereafter; Small growth: S&P SmallCap 600/Barra Growth Index through May 16, 2003, MSCI US Small Cap Growth Index through April 16, 2013, CRSP US Small Cap Growth Index thereafter; Small value: S&P SmallCap 600/Barra Value Index through May 16, 2003, MSCI US Small Cap Value Index through April 16, 2013, CRSP US Small Cap Value Index thereafter. Bond benchmarks are represented by the following Barclays indexes: U.S. 1 5 Year Government Bond Index, U.S. 1 5 Year Corporate Bond Index, U.S. Intermediate Government Bond Index, U.S. Intermediate Corporate Bond Index, U.S. GNMA Bond Index, U.S. Corporate High Yield Bond Index. International and global benchmarks are represented by the following indexes: Global Total International Composite Index through August 31, 2006, MSCI EAFE + Emerging Markets Index through December 15, 2010, MSCI ACWI ex USA IMI Index through June 2, 2013, FTSE Global All Cap ex US Index thereafter; Developed MSCI World ex USA Index; Emerging markets: MSCI Emerging Markets Index. 8

9 Past performance is not a guarantee of future returns Fund leadership is quick to change Quintile rank in subsequent non-overlapping five year period (% of funds) Ending December 2014 Quintile # of funds Excess return rank 5-year ending Dec Highest quintile High Medium Low Lowest quintile Missing Total Highest Quintile (1) 13.5% 16.6% 20.3% 16.2% 23.5% 9.9% 100.0% High (2) 12.4% 13.5% 16.0% 20.6% 15.5% 22.1% 100.0% Medium (3) 14.9% 13.9% 14.2% 17.7% 13.4% 25.9% 100.0% Low (4) 13.8% 15.1% 11.0% 12.3% 10.0% 37.9% 100.0% Lowest Quintile (5) 13.8% 11.5% 10.9% 10.6% 8.7% 44.6% 100.0% Notes: The first two columns rank all active U.S. equity funds within each of the Morningstar style categories based on their excess returns relative to their stated benchmarks during the period cited. The shaded columns show how the funds in each quintile performed over the next five years. Sources: Vanguard and Morningstar, Inc. 9

10 Identifying skill is challenging: Past performance does not help Outperformance is quick to change Percentage of funds in each quintile 25% 20% 15% 10% 5% 0% Subsequent 5-year performance of funds originally ranked in top quintile for the 5-years as of December 31, % 13.5% Remained in top quintile 16.6% Fell to second quintile 20.3% Fell to third quintile 16.2% Fell to fourth quintile Fell to bottom quintile 9.9% Liquidated/ merged Percentage of funds in each quintile 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Subsequent 5-year performance of funds originally ranked in bottom quintile for the 5-years as of December 31, % 11.5% 10.9% 10.6% Rose to top quintile Rose to second quintile Rose to third quintile Rose to fourth quintile 8.7% Remained in bottom quintile 44.6% Liquidated/ merged 3%: Chance of a manager starting in top 20% of all managers and remaining in top 20% over full ten-year period (20% x 13.5%) Sources: Vanguard and Morningstar. Notes: 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 quintile and bottom quintile of funds. There were 5,375 total funds, 1,091 of which fell into the top excess return quintile as of

11 Comparing active to passive 11

12 The indexing cost advantage Index funds generally offer lower costs across asset and sub asset classes Average expense ratios as of December 31, 2014 Investment type Actively managed funds Index funds ETFs U.S. stock U.S. sectors International stocks U.S. bonds Large-cap 0.77% 0.11% 0.14% Mid-cap Small-cap Stock sector Real estate Developed market Emerging market Corporate Government The shareholders net return equals the gross return less the expense ratio and transaction costs Index funds derive their low-cost structure from having low management fees and low turnover The lower the cost drag, the greater the net return Source: Vanguard calculations using data from Morningstar. Expense ratios are asset weighted. Discrepancies due to rounding. Data as of December 31,

13 The impact of cost on mutual fund performance Over longer periods, higher costs generally correlate to lower returns U.S. equity styles U.S. fixed income styles Style outperformance and underperformance (10-year annualized excess return) Value Blend Growth 15% 15% Large cap Scale Mid cap Small cap 0% Scale 3% Cost for each style (Expense ratio) 5% Scale 5% Government Credit High-yield 0% Scale 3% Cost for each style (Expense ratio) Short-term Intermediateterm Sources: Vanguard calculations, using data from MSCI, Barclay s Capital,CRSP, and Morningstar, Inc. All data as of December 31, Notes: Each plotted point represents a U.S. equity mutual fund within the specific size, style, and asset group. Each fund is plotted to represent the relationship of its expense ratio (x-axis) versus its ten year annualized excess return relative to the style benchmark (y-axis). The straight line represents the linear regression, or the best-fit trend line that is, the general relationship of expenses to returns within each asset group. The scales are standardized to show the slopes relationship to each other, with expenses ranging from 0% to 3% and returns ranging from 15% to 15% for equities and from 5% to 5% for fixed income. Some funds expense ratios and returns go beyond the scales and are not shown. Style benchmark returns are represented by the following indexes: Large Blend: MSCI US Prime Market 750 through January 30, 2013, CRSP US Large Cap Index thereafter; Large Value: MSCI US Prime Market 750 Value through April 16, 2013, CRSP US Large Cap Value Index thereafter; Large Growth: MSCI US Prime Market 750 Growth through April 16, 2013, CRSP US Large Cap Growth Index thereafter; Mid Blend: MSCI US Mid Cap 450 through January 30, 2013, CRSP US Mid Cap Index thereafter; Mid Value: MSCI US Mid Cap 450 Value through April 16, 2013, CRSP US Mid Cap Value Index thereafter ; Mid Growth: MSCI US Mid Cap 450 Growth through April 16, 2013, CRSP US Mid Cap Growth Index thereafter; Small Blend: MSCI US Mid Cap 1750 through January 30, 2013, CRSP US Small Cap Index thereafter; Small Value: MSCI US Small Cap 1750 Value through April 16, 2013, CRSP US Small Cap Value index thereafter; Small Growth: MSCI US Small Cap 1750 Growth through April 16, 2013, CRSP US Small Cap Growth Index thereafter. Short-term bond: Barclays Capital US 1-5 Year Credit Index; short-term government bond: Barclays Capital US 1-5 Year Treasury Index; intermediate-term bond: Barclays Capital US 5-10 Year Credit Index; intermediate-term government bond: Barclays Capital US 5-10 Yr Treasury Index; high yield bond: Barclays Capital US Corp High Yield Index. 13

14 Other benefits of indexing 14

15 Indexing offers additional benefits in portfolio construction Indexing permits greater control of asset class risks in a portfolio Using a concentrated active fund would lead to a portfolio with risk and return characteristics differing from the equity market Diversification Actively managed funds tend to hold fewer securities with varying degrees of return correlation Style consistency An index fund maintains its style consistency by closely tracking the characteristics of the index. 15

16 Portfolios of active funds have not enhanced the client experience Portfolios of actively managed funds can lead to increased volatility YR Return 15YR STDEV 10YR Return 10YR STDEV 5YR Return 5YR STDEV 3YR Return 3YR STDEV 1YR Return 1YR STDEV Median U.S. active equity portfolio Median U.S. active bond portfolio Median U.S. active non-u.s. equity portfolio Notes: This illustration of hypothetical portfolios does not represent the returns of any particular investment. Portfolio weights approximate the relative allocations within each market as of December 31, Allocations are as follows: Median active U.S. equity portfolio 70% median large-cap fund/ 20% median mid-cap fund/10% median small-cap fund; median active U.S. bond portfolio 60% median government bond fund/40% median corporate bond fund; median active non- U.S. equity portfolio 80% median developed markets fund/20% median emerging markets fund. The U.S. bond market is represented by the Barclays U.S. Aggregate Bond Index; the U.S. stock market is represented by the Wilshire 5000 Index through April 22, 2005, and the MSCI US Broad Market Index through June 2, 2013, and the CRSP US Total Market Index thereafter; and the international stock market is represented by the MSCI All Country World Index ex USA. Sources: Vanguard calculations, using data from Morningstar, Inc. Data as of December 31,

17 Debunking some misconceptions Active managers outperform in bear markets Percent of managers outperforming market during bull and bear cycles U.S. funds versus Spliced Total Stock Market Index 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Bull 1/ /1972 Bear 1/1973-9/1974 Bull 10/ /1980 Bear 12/1980-7/1982 Bull 8/1982-8/1987 Bear 9/ /1987 Bull 12/1987-5/1990 Bear 6/ /1990 Bull 11/1990-6/1998 Bear 7/1998-8/1998 Bull 9/1998-8/2000 Bear 9/2000-2/2003 Bull 3/ /2007 Bear 11/2007-2/2009 Bull 3/ /2014 Source: Vanguard calculations using data from Morningstar, Wilshire, MSCI, and CRSP. The U.S. stock market is represented by the Wilshire 5000 Index through April 22, 2005, and the MSCI US Broad Market Index through June 2, 2013, and the CRSP US Total Market Index thereafter 17

18 Conclusion 18

19 Conclusion Indexing provides a simplified, efficient investment vehicle with the potential to increase shareholder wealth across a broad range of asset and sub-asset classes Indexed investments have generally offered long-term outperformance relative to a majority of actively managed funds The higher costs of active management provide index funds a significant head start in relative performance 19

20 Disclosures For more information about Vanguard funds, visit or call to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing. All investing is subject to risk, including the possible loss of the money you invest. For institutional use only. Not for distribution to retail investors The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. 20

21 Appendix 21

22 Appendix Asset-weighted excess returns for Morningstar fund categories Morningstar Category 15-Year 10-Year 5-Year 3-Year 1-Year U.S. Equity Large Blend 0.10% -1.19% -2.09% -1.41% -2.76% Large Growth 0.47% -0.52% -1.49% -0.16% -2.78% Large Value 0.80% -0.50% -1.15% -1.05% -2.59% Mid Blend -1.17% -1.57% -1.69% -1.06% -4.61% Mid Growth -2.29% -0.38% -1.59% -1.55% -5.92% Mid Value -1.37% -1.06% -2.10% -2.11% -4.67% Small Blend 0.76% -1.27% -2.41% -2.83% -3.68% Small Growth -2.14% -1.02% -0.77% -0.09% -0.71% Small Value 0.40% -0.48% -2.23% -3.80% -7.20% Non U.S. Equity Developed 0.42% 0.52% 0.34% 0.58% -0.33% Emerging 0.36% -0.35% 0.90% 1.15% -0.61% Global 2.31% 0.94% 0.67% 1.47% -0.57% U.S. Fixed Income Short Corporate -1.24% -1.02% -1.08% -1.08% -0.77% Short Government -0.44% -0.32% -0.37% -0.07% -0.18% Intermediate Corporate -0.04% 0.05% -0.22% -0.33% 0.98% Intermediate Government -0.39% -0.13% -0.18% 0.18% -0.11% GNMA -0.10% -0.05% 0.08% 0.12% 0.42% High-Yield -1.23% -1.08% -0.79% -0.46% -0.39% Note: Performance data reflect periods ending December 31, Sources: Vanguard calculations, using data from Morningstar, Inc. Equity benchmarks are represented by the following indexes Large blend: MSCI US Prime Market 750 Index through January 30, 2013, CRSP US Large Cap Index thereafter; Large growth: S&P 500/Barra Growth Index through May 16, 2003, MSCI US Prime Market Growth Index through April 16, 2013, CRSP US Large Cap Growth Index thereafter; Large value: S&P 500/Barra Value Index through May 16, 2003, MSCI US Prime Market Value Index through April 16, 2013, CRSP US Large Cap Value Index thereafter; Mid blend: S&P MidCap 400 Index through May 16, 2003, MSCI US Mid Cap 450 Index through January 30, 2013, CRSP US Mid Cap Index thereafter; Mid growth: MSCI US Mid Cap Growth Index through April 16, 2013, CRSP US Mid Cap Growth Index thereafter; Mid value: MSCI US Mid Cap Value Index through April 16, 2013, CRSP US Mid Cap Value Index thereafter; Small blend: Russell 2000 Index through May 16, 2003, MSCI US Small Cap 1750 Index through January 30, 2013, CRSP US Small Cap Index thereafter; Small growth: S&P SmallCap 600/Barra Growth Index through May 16, 2003, MSCI US Small Cap Growth Index through April 16, 2013, CRSP US Small Cap Growth Index thereafter; Small value: S&P SmallCap 600/Barra Value Index through May 16, 2003, MSCI US Small Cap Value Index through April 16, 2013, CRSP US Small Cap Value Index thereafter. Bond benchmarks are represented by the following Barclays indexes: U.S. 1 5 Year Government Bond Index, U.S. 1 5 Year Corporate Bond Index, U.S. Intermediate Government Bond Index, U.S. Intermediate Corporate Bond Index, U.S. GNMA Bond Index, U.S. Corporate High Yield Bond Index. International and global benchmarks are represented by the following indexes: Global Total International Composite Index through August 31, 2006, MSCI EAFE + Emerging Markets Index through December 15, 2010, MSCI ACWI ex USA IMI Index through June 2, 2013, FTSE Global All Cap ex US Index thereafter; Developed MSCI World ex USA Index; Emerging markets: MSCI Emerging Markets Index. 22

23 Active management is a difficult proposition: Comparison to self selected benchmark The record of actively managed funds versus their prospectus benchmark U.S. Equity Percent underperforming 15-Year 10-Year 5-Year 3-Year 1-Year Median surviving fund excess return Percent underperforming Median surviving fund excess return Percent underperforming Median surviving fund excess return Percent underperforming Median surviving fund excess return Percent underperforming Morningstar category Unadjusted Adjusted Unadjusted Adjusted Unadjusted Adjusted Unadjusted Adjusted Unadjusted Adjusted Large Blend 52% 81% -0.05% 76% 88% -0.78% 83% 89% -1.80% 70% 76% -1.37% 77% 79% Large Growth 44% 75% 0.29% 66% 83% -0.50% 83% 88% -1.55% 65% 71% -0.74% 81% 82% Large Value 43% 76% 0.26% 72% 85% -0.67% 89% 92% -1.92% 83% 86% -1.99% 89% 90% Mid Blend 50% 78% -0.02% 79% 89% -1.08% 78% 85% -1.33% 71% 77% -1.45% 84% 86% Mid Growth 52% 79% -0.05% 67% 84% -0.78% 85% 90% -1.98% 83% 86% -2.46% 86% 87% Mid Value 57% 78% -0.94% 70% 79% -0.81% 82% 86% -1.71% 73% 75% -1.22% 82% 83% Small Blend 42% 69% 0.56% 51% 69% -0.04% 59% 67% -0.42% 62% 66% -1.17% 58% 62% Small Growth 36% 71% 1.02% 56% 79% -0.17% 67% 77% -0.97% 77% 82% -2.13% 78% 80% Small Value 38% 66% 0.43% 34% 58% 0.43% 53% 65% -0.09% 59% 63% -0.58% 56% 59% Median surviving fund excess return Non U.S. Equity Developed 57% 79% -0.31% 57% 75% -0.29% 49% 61% 0.07% 53% 61% -0.18% 65% 68% Emerging 53% 75% -0.12% 69% 77% -0.67% 64% 71% -0.72% 52% 59% -0.13% 63% 70% Global 41% 74% 0.72% 59% 74% -0.35% 59% 71% -0.45% 57% 65% -0.63% 79% 82% U.S. Fixed Income Short Corporate 68% 80% -0.32% 62% 77% -0.22% 37% 50% 0.32% 32% 39% 0.46% 60% 65% Short Government 84% 94% -0.56% 83% 92% -0.53% 76% 85% -0.55% 68% 76% -0.29% 65% 70% Intermediate Corporate 63% 84% -0.21% 55% 76% -0.11% 30% 48% 0.48% 22% 33% 0.76% 71% 73% Intermediate Government 89% 95% -0.71% 84% 90% -0.59% 78% 84% -0.58% 71% 74% -0.42% 78% 79% GNMA 93% 97% -0.40% 68% 83% -0.47% 68% 76% -0.47% 79% 84% -0.44% 77% 82% High-Yield 90% 95% -1.20% 89% 93% -1.15% 80% 84% -0.91% 72% 77% -0.72% 74% 78% Sources: Vanguard calculations, using data from Morningstar, Inc. Fund classifications provided by Morningstar; Benchmarks reflect those identified in each fund s prospectus. Data as of December 31, Note that most index funds underperform their benchmarks due to fees. Past performance is not a guarantee of future results. 23

24 Active management is a difficult proposition: Comparison to style benchmark The record of actively managed funds versus style benchmark U.S. Equity Percent underperforming 15-Year 10-Year 5-Year 3-Year 1-Year Median surviving fund excess return Percent underperforming Median surviving fund excess return Percent underperforming Median surviving fund excess return Percent underperforming Median surviving fund excess return Percent underperforming Morningstar category Unadjusted Adjusted Unadjusted Adjusted Unadjusted Adjusted Unadjusted Adjusted Unadjusted Adjusted Large Blend 57% 83% -0.27% 83% 92% -1.12% 84% 89% -1.89% 70% 76% -1.43% 79% 79% -2.32% Large Growth 49% 77% 0.03% 80% 90% -1.08% 88% 92% -2.00% 74% 79% -1.27% 87% 88% -3.52% Large Value 32% 71% 0.76% 70% 84% -0.62% 86% 90% -1.56% 76% 80% -1.57% 89% 89% -2.69% Mid Blend 75% 89% -1.03% 91% 95% -1.65% 90% 93% -2.06% 78% 82% -1.92% 95% 95% -5.99% Mid Growth 74% 89% -2.19% 71% 86% -0.96% 85% 90% -1.95% 80% 84% -2.24% 96% 96% -6.26% Mid Value 95% 98% -2.55% 86% 90% -1.13% 90% 92% -1.99% 86% 88% -2.05% 89% 89% -4.63% Small Blend 39% 66% 1.01% 85% 90% -1.50% 82% 86% -1.90% 78% 81% -2.44% 87% 87% -3.10% Small Growth 82% 91% -2.77% 87% 94% -1.25% 71% 79% -1.25% 68% 74% -1.00% 63% 65% -0.95% Small Value 44% 69% 0.20% 79% 86% -0.81% 91% 93% -2.17% 94% 95% -3.50% 99% 99% -6.51% Median surviving fund excess return Non U.S. Equity Developed 59% 80% -0.44% 61% 77% -0.51% 57% 68% -0.33% 60% 67% -0.62% 67% 68% -1.48% Emerging 65% 81% -0.45% 81% 86% -1.07% 54% 63% -0.15% 48% 54% 0.15% 59% 60% -0.92% Global 31% 68% 0.81% 49% 66% 0.10% 41% 56% 0.49% 47% 55% 0.22% 68% 69% -1.56% U.S. Fixed Income Short Corporate 94% 96% -1.45% 94% 96% -1.34% 88% 90% -1.59% 89% 90% -1.57% 91% 91% -1.20% Short Government 76% 90% -0.55% 82% 91% -0.60% 71% 81% -0.52% 68% 74% -0.28% 65% 68% -0.41% Intermediate Corporate 80% 91% -0.58% 74% 86% -0.46% 71% 79% -0.50% 78% 81% -0.95% 22% 24% 1.06% Intermediate Government 91% 96% -0.64% 77% 86% -0.44% 80% 84% -0.48% 47% 52% 0.04% 60% 61% -0.20% GNMA 85% 90% -0.37% 72% 80% -0.43% 68% 72% -0.43% 71% 75% -0.39% 76% 78% -0.63% High-Yield 94% 97% -1.17% 95% 97% -1.36% 89% 90% -1.12% 79% 80% -0.94% 77% 77% -1.00% Note: Performance data reflect periods ending December 31, Sources: Vanguard calculations, using data from Morningstar, Inc. Equity benchmarks are represented by the following indexes Large blend: MSCI US Prime Market 750 Index through January 30, 2013, CRSP US Large Cap Index thereafter; Large growth: S&P 500/Barra Growth Index through May 16, 2003, MSCI US Prime Market Growth Index through April 16, 2013, CRSP US Large Cap Growth Index thereafter; Large value: S&P 500/Barra Value Index through May 16, 2003, MSCI US Prime Market Value Index through April 16, 2013, CRSP US Large Cap Value Index thereafter; Mid blend: S&P MidCap 400 Index through May 16, 2003, MSCI US Mid Cap 450 Index through January 30, 2013, CRSP US Mid Cap Index thereafter; Mid growth: MSCI US Mid Cap Growth Index through April 16, 2013, CRSP US Mid Cap Growth Index thereafter; Mid value: MSCI US Mid Cap Value Index through April 16, 2013, CRSP US Mid Cap Value Index thereafter; Small blend: Russell 2000 Index through May 16, 2003, MSCI US Small Cap 1750 Index through January 30, 2013, CRSP US Small Cap Index thereafter; Small growth: S&P SmallCap 600/Barra Growth Index through May 16, 2003, MSCI US Small Cap Growth Index through April 16, 2013, CRSP US Small Cap Growth Index thereafter; Small value: S&P SmallCap 600/Barra Value Index through May 16, 2003, MSCI US Small Cap Value Index through April 16, 2013, CRSP US Small Cap Value Index thereafter. Bond benchmarks are represented by the following Barclays indexes: U.S. 1 5 Year Government Bond Index, U.S. 1 5 Year Corporate Bond Index, U.S. Intermediate Government Bond Index, U.S. Intermediate Corporate Bond Index, U.S. GNMA Bond Index, U.S. Corporate High Yield Bond Index. International and global benchmarks are represented by the following indexes: Global Total International Composite Index through August 31, 2006, MSCI EAFE + Emerging Markets Index through December 15, 2010, MSCI ACWI ex USA IMI Index through June 2, 2013, FTSE Global All Cap ex US Index thereafter; Developed MSCI World ex USA Index; Emerging markets: MSCI Emerging Markets Index. 24

25 Impact of market cycles on active managers Evaluate performance across time and style benchmarks Percent of funds underperforming style benchmark Five years ended Large Blend 95% 89% 75% 65% 56% 49% 44% 58% 67% 74% 65% 64% 68% 72% 77% 76% 84% Large Growth 99% 90% 63% 67% 56% 33% 44% 65% 55% 36% 55% 63% 74% 79% 88% 76% 88% Large Value 86% 93% 82% 55% 39% 41% 31% 34% 74% 81% 70% 50% 49% 45% 51% 56% 86% Mid-Cap Blend 84% 73% 76% 79% 70% 61% 67% 64% 83% 86% 73% 71% 70% 72% 65% 83% 90% Mid-Cap Growth 87% 69% 89% 94% 88% 78% 77% 82% 84% 77% 45% 53% 48% 51% 53% 73% 85% Mid-Cap Value 78% 65% 86% 85% 86% 72% 84% 84% 93% 77% 77% 64% 51% 58% 75% 73% 90% Small Blend 42% 63% 21% 20% 20% 19% 22% 39% 52% 83% 62% 66% 69% 69% 78% 78% 82% Small Growth 28% 24% 28% 35% 61% 59% 79% 83% 86% 73% 74% 81% 81% 83% 85% 77% 71% Small Value 81% 77% 86% 79% 47% 25% 28% 22% 30% 34% 55% 48% 45% 42% 60% 61% 91% Cyclicality is influenced by the relative performance across styles Managers have holdings that fall within other boxes beta of less than 1 With wide dispersion across style boxes, we would therefore expect managers in the lower performing boxes to stand a greater chance of outperforming their respective style box Similarly, during periods of strong performance within that style, the index will tend to outperform a greater percentage of the managers Source: Vanguard calculations using data from Morningstar, MSCI, CRSP, and Standard & Poors. Benchmarks are represented by the following indexes Large blend: MSCI US Prime Market 750 Index through January 30, 2013, CRSP US Large Cap Index thereafter; Large growth: S&P 500/Barra Growth Index through May 16, 2003, MSCI US Prime Market Growth Index through April 16, 2013, CRSP US Large Cap Growth Index thereafter; Large value: S&P 500/Barra Value Index through May 16, 2003, MSCI US Prime Market Value Index through April 16, 2013, CRSP US Large Cap Value Index thereafter; Mid blend: S&P MidCap 400 Index through May 16, 2003, MSCI US Mid Cap 450 Index through January 30, 2013, CRSP US Mid Cap Index thereafter; Mid growth: MSCI US Mid Cap Growth Index through April 16, 2013, CRSP US Mid Cap Growth Index thereafter; Mid value: MSCI US Mid Cap Value Index through April 16, 2013, CRSP US Mid Cap Value Index thereafter; Small blend: Russell 2000 Index through May 16, 2003, MSCI US Small Cap 1750 Index through January 30, 2013, CRSP US Small Cap Index thereafter; Small growth: S&P SmallCap 600/Barra Growth Index through May 16, 2003, MSCI US Small Cap Growth Index through April 16, 2013, CRSP US Small Cap Growth Index thereafter; Small value: S&P SmallCap 600/Barra Value Index through For institutional May 16, use 2003, only. MSCI Not US for Small public Cap distribution. Value Index through April 16, 2013, CRSP US Small Cap Value Index thereafter. 25