The role of indexed strategies in client portfolios Walter H. - - PowerPoint PPT Presentation

The role of indexed strategies in client portfolios

Walter H. Lenhard, CFA Vanguard Quantitative Equity Group

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Indexed strategies benefit clients and advisors

• The difficulty of active management
• Why indexing works
• Indexing’s role in a client portfolio

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• Actively managed funds have

underperformed across asset and sub-asset classes

• Generally due to high costs and

reasonably efficient markets

• Investors seeking
• utperformance have been

disappointed as expectations have not been met

Value Blend Growth Large 56% 83% 73% 0.08% (1.38%) (1.04%) Medium 99% 96% 98% (2.63)% (2.51%) (3.75%) Small 84% 93% 76% (1.34%) (3.11)% (0.66)%

Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Sources: Vanguard calculations using data from Morningstar, MSCI, S&P, and Barclays Capital. 15 years as of December 31, 2009. Equity benchmarks are represented by the following indexes: Large Blend: S&P 500: 1/1995 - 11/2002, MSCI Prime Market 750: 12/2002 - Current; Large Value: S&P 500 Value: 1/1995 - 11/2002, MSCI Prime Market 750 Value: 12/2002 - Current; Large Growth: S&P 500 Growth 1/1995 - 11/2002, MSCI Prime Market 750 Growth 12/2002 - Current; Mid Blend: S&P Midcap 400: 1/1995 - 11/2002, MSCI Mid Cap 450: 12/2002 - Current; Mid Value: S&P Midcap 400 Value: 1/1995 - 11/2002, MSCI Mid Cap 450 Value: 12/2002 - Current; Mid Growth: S&P Midcap 400 Growth: 1/1995 - 11/2002, MSCI Mid Cap 450 Growth: 12/2002 - Current; Small Blend: S&P Small Cap 600: 1/1995 - 11/2002, MSCI Mid Cap 1750: 12/2002 - Current; Small Value: S&P Smallcap 600 Value: 1/1995 - 11/2002, MSCI Small Cap 1750 Value: 12/2002 - Current; Small Growth: S&P Small cap 600 Growth: 1/1995 - 11/2002, MSCI Small Cap 1750 Growth: 12/2002 – Current Bond benchmarks are represented by the following Barclays Capital indexes: U.S. 1–5 Year Government Bond Index, U.S. 1–5 Year Credit Bond Index, U.S. Intermediate Government Bond Index, U.S. Intermediate Credit Bond Index, U.S. GNMA Index, U.S. Corporate High Yield Bond Index. *Long government and long corporate funds were excluded due to a small sample size and a duration mismatch with available long-term bond benchmarks. Because duration is the dominant return factor, small differences in duration between a fund (or group of funds) and an index can lead to significant out- or underperformance, independent of cost differentials.

Government Corporate GNMA High-Yield Short 94% 99% 100% 93% (.79)% (1.61%) (0.72%) (1.02%) Intermediate 80% 91% (0.27)% (0.83)% % underperforming benchmark - adjusted for survivorship bias Median fund excess return

Relative performance of actively managed funds

Developed Mkts Emerging Mkts 56% 64% 0.34% (0.27%)

On average, active management has not added value

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And among those that do add value, leadership is quick to change

Risk-Adjusted Return Rank 5-Years Ending Dec 1999 Rank in Subsequent Non-Overlapping Five Year Period (% of funds) Ending Dec 2004 Highest Quintile High Medium Low Lowest Quintile Missing Total Highest Quintile (1) 7.1% 9.8% 19.3% 22.0% 31.5% 10.4% 100.0% High (2) 11.5% 16.7% 19.4% 26.4% 18.8% 7.3% 100.0% Medium (3) 18.7% 16.6% 20.5% 18.7% 15.7% 9.7% 100.0% Low (4) 18.9% 27.8% 19.2% 11.1% 7.2% 15.9% 100.0% Lowest Quintile (5) 33.4% 17.4% 7.6% 7.6% 8.5% 25.6% 100.0%

Source: Vanguard and Morningstar. Notes: The far left column ranks all active U.S. equity funds based on their risk adjusted excess returns relative to their peer group (Morningstar category) during the five year period as of the date listed. Each quintile includes the funds within that quintile from each of the 9-style Morningstar categories. The remaining columns show how these quintiles performed over the next non-overlapping five years.

Risk-Adjusted Return Rank 5-Years Ending Dec 1999 Rank in 2nd Subsequent Non-Overlapping Five Year Period (% of funds) Ending Dec 2009 Highest Quintile High Medium Low Lowest Quintile Missing Total Highest Quintile (1) 18.4% 12.8% 12.2% 16.9% 15.7% 24.0% 100.0% High (2) 17.9% 14.8% 13.9% 12.7% 14.5% 26.1% 100.0% Medium (3) 14.5% 17.2% 16.9% 13.9% 14.2% 23.3% 100.0% Low (4) 14.7% 12.0% 14.4% 16.2% 13.5% 29.3% 100.0% Lowest Quintile (5) 7.6% 13.2% 12.6% 11.4% 11.7% 43.5% 100.0% 64% chance for top quintile fund to underperform in subsequent 5 years 55% chance for top quintile fund to underperform in next 5 years as well

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4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 5 10 15 20 25

Annual Volatility (%) Annual Return (%)

This can lead to portfolios that may not live up to expectations

US Stock Market

Active funds represented by the average portfolio of active funds. US Equity portfolio was constructed by dividing the US equity allocation into large (70%), mid (20%) and small (10%), approximating the historical weights for the US stock market. Within each, we divided the allocation equally between growth, value and blend. US stock market represented by the Dow Jones Total US Stock Market Index from 1995 through 5/2005 and MSCI Broad Market Index thereafter. Fixed income portfolio constructed by dividing the intermediate term bond market into corporate (36%) and government (64%) sectors. US bond market represented by the Barclay’s Aggregate Bond Index. International portfolio constructed by dividing the international market into developed (78%) and Emerging (22%). International stock market represented by the MSCI AC world Ex US Index. Fund data provided by Morningstar. Data includes liquidated and merged funds. Data covers the period 1995 through 2009.

Average active US equity portfolio Average active bond portfolio US Bond Market International Stock Market Average active international stock portfolio

Portfolios of actively managed funds can increase risk and/or lower returns

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Why does indexing work?

• The zero-sum game
• Costs
• Portfolio and market dynamics

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The zero sum game means that after cost, a majority of dollars will underperform the costless market benchmark

• The holdings of all investors aggregate to form a market
• Outperformance by one, necessarily means underperformance by another
• The key to increasing the likelihood of remaining on the winning side is by

lowering costs (but maintaining skill)

Source: Vanguard Investment Strategy Group

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Indexed strategies have a built in cost advantage

Source: Vanguard calculations using data from Morningstar Expense ratios are asset weighted. Data as of December 31, 2009.

Index funds generally offer lower costs across asset and sub asset classes

Actively Managed Funds Index Funds Difference Large Cap US Equity 86 bps 19 bps 68 bps Mid Cap US Equity 106 bps 24 bps 82 bps Small Cap US Equity 114 bps 32 bps 82 bps US Sector Funds 107 bps 81 bps 26 bps US Real Estate Funds 104 bps 26 bps 78 bps International Developed Markets 99 bps 40 bps 59 bps International Emerging Markets 136 bps 41 bps 96 bps US Corporate Bond Funds 56 bps 23 bps 33 bps US Government Bond Funds 54 bps 23 bps 30 bps

• Net return equals the gross return less expense ratio and transaction costs
• Index funds have low management fees and low turnover
• The lower the cost drag, the greater the net return

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The zero sum game is difficult to overcome for the average actively managed equity fund

• Several factors contribute to the wide distribution in addition to differences in

cost and manager skill. –

Factor differentials to peers and benchmarks amplify return dispersion

–

Wider security distribution

Sources: Morningstar, Dow Jones, and Vanguard Investment Strategy Group as of December 31, 2009. * Data includes only funds that survived the respective 10, 15 or 20-year period. When removing the effects of survivor bias, the underperforming funds fall to 64% worse for 10-years, 76% worse for 15-years, and 71% worse for 20-years.

50 100 150 200 250 300 350 400

<–11 –11 to –10 –10 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 to 11 > 11

Percentage Point Difference From US Stock Market

10 year 15 year 20 year

Annualized Excess Returns Versus U.S. Stock Market: As of 12/31/2009 Dow Jones U.S. Total Stock Market Index 10-Years: 1279 Worse (41%)* 15-Years: 748 Worse (61%)* 20-Years: 256 Worse (52%)* 10-Years: 1845 Better (59%) 15-Years: 472 Better (39%) 20-Years: 235 Better (48%) Number of Funds

> 10 100 200 300 400 500 600

Less than -4% Between -4% and - 3% Between -3% and - 2% Between -2% and - 1% Between -1% and 0% Between 0% and 1% Between 1% and 2% Between 2% and 3% Between 3% and 4% Greater than 4%

10 year 15 year 20 year

And even more so for the average bond fund

• Unlike equities, returns are concentrated around the market return.

–

Returns are primarily determined by interest rates, the yield curve, credit quality and the active manager’s positioning relative to peers and benchmarks.

–

Narrower security distribution

Source: Vanguard calculations using data from Morningstar and Barclays Capital. Data as of December 31, 2009. * Data includes only funds that survived the respective 10, 15, or 20-year period. When removing the effects of survivorship bias, the underperforming funds fall To 90% worse for 10-years, 92% worse for 15-years and 86% worse for 20-years.

Annualized Excess Returns Versus U.S. Bond Market: As of 12/31/2009

Barclay’s Capital US Aggregate Index

10-Years: 1321 Worse (84%)* 15-Years: 709 Worse (85%)* 20-Years: 251 Worse (76%)* 10-Years: 255 Better (16%) 15-Years: 123 Better (15%) 20-Years: 81 Better (24%) Number of Funds

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0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Bull Market: 1/1971- 12/1972 Bear Market: 1/1973- 9/1974 Bull Market: 10/1974- 11/1980 Bear Market: 12/1980- 7/1982 Bull Market: 8/1982- 8/1987 Bear Market: 9/1987- 11/1987 Bull Market: 12/1987- 5/1990 Bear Market: 6/1990- 10/1990 Bull Market: 11/1990- 6/1998 Bear Market: 7/1998- 8/1998 Bull Market: 9/1998- 8/2000 Bear Market: 9/2000- 2/2003 Bull Market: 3/2003- 10/2007 Bear Market: 11/2007- 12-2008

Percent of managers outperforming market during bull and bear cycles

Source: Vanguard calculations using data from Morningstar, and Dow Jones

US Funds versus Dow Jones US Total Stock Market Index

One fallout of this cyclicality is that active managers have not benefited on average from market cycles

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And helps to explain why those who change managers are often disappointed

Institutional investment management hire/fire decision 1996–2003

Amount of excess return

Years before manager change Years after manager change 3 2 1 1 2 3

Fired firm

2.27 (2.06) (0.74) 0.98 1.47 3.30

Hired firm

10.39 7.04 3.42 0.42 1.12 1.88

Difference

8.12 9.10 4.16 (0.56) (0.35) (1.42)

Source: The Selection and Termination of Investment Management Firms by Plan Sponsors Amit Goyal, Sunil Wahal (Journal of Finance Volume 63, Issue 4, printed August 2008) 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 the period 1996 through 2003.

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The role of indexing in a client portfolio

• The case for indexing is strong, but it’s not

absolute

• Combining active and passive

> 14 *Data only includes Vanguard active equity funds with a 10-year performance history. **Vanguard active equity funds are compared by excess return to their passive benchmarks. Excess return is the difference between the NAV return and the benchmark at any given point in time. Funds outperforming their benchmark are plotted to the right of the center rule, according to scale. ***Vanguard active equity funds are compared to their actively managed peers by percentage of outperformance. Vanguard funds outperforming their peer group by more than 50% fall above the 50% line in the top half of the chart. Sources: Lipper and Vanguard. Data as of December 31, 2009.

Active management can work, given the right environment

Vanguard active equity fund performance

10-year relative active equity performance versus passive benchmarks and actively managed peers*

• Markets are not perfectly efficient
• Outperformance largely dependent

upon:

– Low costs – Talent – Discipline – Asset location

Versus Passive Benchmark**

Versus Active Peers***

Below Above Top Half Bottom Half (0 funds) (4 funds) (16 funds) (2 funds)

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And relative performance can be very positive in the short term

Source: Vanguard calculations using data from Morningstar S&P and MSCI From 1986 through 11/2002 we use the S&P 500 Growth and S&P 500 Value indexes. Since 12/2002 we use the MSCI Prime Market 750 Growth and Value indexes.

Rolling Excess Returns for Large Cap Value and Large Cap Growth Funds

• 30%
• 20%
• 10%

0% 10% 20% 30% 40% Dec-86 Dec-87 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 12-Month Excess Return Large Value Large Growth

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Portfolio weights 100% Index Portfolio Active A Active B 50% Index/ 50% Active A 50% Index/ 50% Active B

Spliced Total Stock Market Index 100% 0% 0% 50.0% 50.0% Average Large-Cap Growth Fund 35.0 17.5 Average Large-Cap Value Fund 35.0 17.5 Average Mid-Cap Core Fund 15.0 7.5 Average Small-Cap Core Fund 15.0 7.5 Average Multi-Cap Growth Fund 50.0 25.0 Average Multi-Cap Value Fund 50.0 25.0

Rankings of semiannual returns, 1982–2009

Worst Best

The returns of active/passive combinations (the circles) fell between those of all-active and all-index portfolios

> 16 FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION.

Analysis of five possible portfolios in 56 semiannual periods during 1982–2009. A spliced index—the Dow Jones Wilshire 5000 Index through April 22, 2005, and the MSCI US Broad Market Index thereafter— was used as a proxy for a broad-market index portfolio. (Index performance does not reflect real-world operating costs, which could alter the results.) The active portfolios were combinations of Lipper fund category averages roughly approximating the market capitalization of the broad market. Past performance is no guarantee of future results. These hypothetical examples are not representative of any particular investment, as you cannot invest directly in an index or a fund-group average. Sources: Vanguard and Lipper Inc.

Combining active portfolios with indexed portfolios combines risk control with the opportunity to outperform

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How will clients react when a strategy is out of favor

Client Asks Questions Client Pulls Some Assets Client Pulls Most Assets Update Resume US Stock Market Return

On average this portfolio has added alpha for a client

• No strategy works consistently year over year
• It’s during those periods where a strategy is out of favor where

clients may not appreciate the long-term track record

• This is where indexing can help

But the advisor faces a risk of losing clients Portfolio’s periodic returns

> 18 Client Asks Questions Client Pulls Some Assets Client Pulls Most Assets Update Resume US Stock Market Return

On average this portfolio has still added alpha

Adding a broad market index fund dilutes alpha, but can temper the drawdown

But the advisor faces a lesser risk of losing clients

• Combining index and active strategies, maintains positive alpha,

but truncates the extreme downside risk of active management

Portfolio’s periodic returns

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Indexing offers additional benefits in portfolio construction

• Greater control of asset class risks
• Diversification
• Style consistency
• Tax advantages

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Conclusion

• On average active management has not met investor

expectations

• Index funds derive their long term performance

advantage from lower costs, style purity and the relative efficiency of the capital markets

• Despite the averages, opportunities do exist for active

management to add value

• Combining index and active strategies can truncate

downside risk, and lead to improved client retention