I’m Chuck Riley, a senior financial planner at Vanguard, and I have a confession to make.
I invest in actively managed funds.
That’s right. I work for the company that introduced the first index fund for individual investors and championed the passive approach to the point that many investors consider Vanguard to be synonymous with indexing. My job, in fact, is to recommend funds to Vanguard clients, and guess which funds I recommend most? Index funds. I’ve also seen all the research that most active funds struggle to consistently outperform index funds. Believe me, I know. I know.
But I can’t help it. I use five Vanguard active funds—three stock, two bond—for one-third of my personal 401(k) portfolio. On purpose. Why??
Am I smarter than everyone else? Am I stupid? Am I a hypocrite?
No. I think my index funds are great, but I also like my low-cost active funds. Here’s why.
The investment markets are not 100% efficient
Last year, my wife Marguerite and I got a nice deal on a house, buying it for less than what we thought it was worth. That concept plays out in the stock and bond markets as well. Individual stocks and bonds are often not priced for what they’re actually worth. Someone with a sharp eye and keen insight (and maybe a little luck, such as with our house purchase) can spot opportunities and make money off them. That’s what active fund managers get paid to do, and many do it very well.
My investment costs are still low
Of course, paying a fund manager for his or her expertise, along with the greater costs of the increased transactions they make, means active funds cost more than index funds. But “higher cost” cannot mean “high cost.” I may be a big believer in market inefficiency, but I am an even bigger believer in the Vanguard principle that low costs translate into higher potential returns.
Including my five active funds, my portfolio’s average expense ratio is just 0.14%. That’s even lower than the 0.19% average portfolio expense ratio for Vanguard investors overall.* Better to compare against the average index fund? Yes, that’s right – Vanguard offers actively managed funds that have lower costs than many index funds. So I’m still getting a very good bang for my investment bucks.
It’s a behavioral thing
When it comes down to it, I have active funds for the same reason that other investors do: the chance to outperform. I don’t want the same returns as everyone else; I want to “win” with my investments!
I feel great when one of the funds I picked beats its benchmark, or the market overall, in a given time period. Granted, it doesn’t happen all the time—the chance to outperform always walks hand-in-hand with the chance to underperform. But even in down years, I take solace in the fact that the active funds always deliver different returns from the index funds, thus providing a little extra diversification.
(To see what I mean, compare the year-to-year performances of Vanguard Total Stock Market Index Fund and Vanguard Diversified Equity Fund. Both funds provide complete exposure to the U.S. stock market, the first through indexing, the second through active management, but perform differently.)
On track to reach our goals
Has an index/active approach translated into investment success? So far, so good. According to Vanguard’s retirement analysis tools (the same tools I use with my clients), Marguerite and I are on track to reach our goal of being able to retire around 2035—which is really the only measure of success that matters. The portfolio has also met my performance expectations, which has helped me stick with it year-in, year-out, especially through rocky periods like 2008–2009.
When I started in 1998 as a writer at Vanguard—with no investing knowledge whatsoever—I thought index funds and active funds were a contradiction of terms. I’ve since learned that both approaches have their merits and can help me reach my investing goals.
Phew. It feels good to finally have things out in the open.
*Sources: Portfolio Watch tool on vanguard.com, and Vanguard.
Warning: Vanguard bloggers are writing a series of posts about why they hold particular investments. It would be unwise to use the posts as a source of guidance for your own portfolio. These holdings reflect the bloggers’ unique situations, perhaps even their missteps. If you need help with an investment portfolio, stop reading this blog and explore the useful tools on vanguard.com.