Specifically, Wallick cites three common pitfalls that investors should avoid:
- Performance chasing.
- Paying too much for your investments.
- Expecting a fund to beat the market all the time.
Mistake #1. Performance chasing
It’s tempting to look at past performance when shopping for a new fund. But if you’re buying or selling a fund based solely on past performance, you could be setting yourself up for disappointment.
Because luck or undue risk-taking can play a significant role in how well a fund does, past performance should be only one of several factors in picking a fund.
At Vanguard, the team that hires managers to run Vanguard’s active funds looks closely at the people, processes, and philosophy that drive investment decisions and, ultimately, a fund’s performance. Here’s a snapshot of the questions our Manager Search and Oversight Group is asking:
|Firm||Is there a culture of investment excellence and stewardship? Is the firm financially stable and viable?|
|People||Are the key investors experienced, talented, and passionate? Do they have the courage to have a different view but the humility to correct a mistake?|
|Philosophy||Does the firm have a clear philosophy on how it seeks to add value that is universally shared by its investment personnel?|
|Process||Does the firm have a competitive advantage enabling it to execute its process well and consistently over time? Can the process be effectively implemented for the assets to be managed?|
|Portfolio||Do the firm’s historical portfolio holdings and characteristics align with its philosophy and process?|
|Performance||Are the firm’s drivers of historical performance logical? Are they sustainable over the long term?|
For more information on how we evaluate fund managers, click here.
Mistake #2. Paying too much for your investments
Good performance is worth paying for—just not too much.
While high-cost funds that beat the market exist, our research found that the least expensive active funds had better odds of beating their benchmarks than the most expensive funds. That’s because lower costs allow you to keep a greater portion of your investment’s return.
For example, a higher-cost fund that charges 1.5% compared with a lower-cost fund, which charges 0.3%, would need to outperform by a little more than 1.2% before it catches up to the lower-cost fund, assuming both funds earn the same returns.
As the following chart shows, paying less can increase your chances of active investing success.
Lower costs boost your chances of active investing success
Percentage of actively managed funds that have outperformed their benchmark
Notes: Data are as of December 31, 2014. Because of fees, most index funds also underperform their benchmarks. Our analysis was based on expenses and fund returns for active equity funds available to U.S. investors at the start of each period. The oldest and lowest-cost single share class was used to represent a fund when multiple share classes existed. Each fund’s performance was compared with that of its prospectus benchmark. Funds that were merged or liquidated were considered underperformers for the purposes of this analysis. The following fund categories were included: small-cap value, small-cap growth, small-cap blend, mid-cap value, mid-cap growth, mid-cap blend, large-cap value, large-cap growth, and large-cap blend.
Sources: Vanguard calculations, using data from Morningstar, Inc.
The chart above shows the portion of actively managed equity funds that have outperformed their prospectus benchmarks in the United States over various periods. The blue bars indicate funds in the least expensive quartile; the purple bars represent those in the most expensive quartile. The conclusion? A higher portion of low-cost funds outperformed their benchmark compared with that of high-cost funds.
Mistake #3. Expecting a fund to beat the market all the time
Investors don’t like losses, especially if they expect to outperform the market. But underperformance is inevitable; in fact, stretches of underperformance are common among even the best managers.
According to our research, of the 2,202 active equity funds in existence at the start of 2001, 476 outperformed. But 98% of those 468 outperforming funds underperformed in at least 4 out of the 15 years ended December 31, 2015.2
While it might be tempting to abandon a fund during a rough patch, if you can hold tight, you can enjoy the potential rewards if and when a fund’s performance rebounds. For such a reason, having appropriate expectations and maintaining patience with high-quality managers who faithfully follow a process is critical to realizing long-term outperformance.
Talent, cost, and patience are our active pillars
There are no shortcuts to identifying the right managers to invest with, but avoiding these three common mistakes can get you closer to reaping the rewards of long-term active investing success. Our belief is that investing in low-cost funds combined with a rigorous and thoughtful manager-selection process (to identify top talent) can help improve your odds of success in active investing. Finally, having the patience to endure inevitable periods of underperformance through time is critical to realizing the long-term success of outperformance.
For more information on Vanguard’s active investing philosophy, read our research: Keys to improving the odds of active management success.
1 Vanguard calculations based on data from Morningstar, Inc.
2 Data are as of December 31, 2015. Our analysis was based on expenses and fund returns for active equity funds available to U.S. investors at the start of the period. The oldest and lowest-cost share class was used to represent a fund when multiple share classes existed. Each fund’s performance was compared with that of its prospectus benchmark. Funds that were merged or liquidated were considered underperformers for the purpose of this analysis. The following fund categories were included: small-cap value, small-cap growth, small-cap blend, mid-cap value, mid-cap growth, mid-cap blend, large-cap value, large-cap growth, and large-cap blend. Sources: Vanguard calculations, based on data from Morningstar, Inc.
Source: Daniel Wallick