I was intrigued by this Vanguard response to PIMCO’s defense of active bond management in which a Vanguard spokesman said:
“We believe the most crucial factor for investing success is cost”
This is an empirically incorrect statement. Yes, costs matter a great deal. But the way you choose to allocate your assets is far more important to your returns than the costs you incur.
Now, the Vanguard statement was probably more true when the firm was founded and John Bogle was on the rampage against stock pickers charging 2% or 3% for their services. But the cost of asset allocation has come down significantly over the last decade. In fact, I’d argue that Vanguard is the leader in funds that are essentially inexpensive, but actively allocated.
Of course, regulars know that I think this “active” vs “passive” debate is misleading to begin with. Anyone with a sound understanding of macro finance knows that there is only ONE true passive portfolio and that’s the Global Financial Asset Portfolio (see here for details). That is, there is really only one outstanding portfolio of all the world’s financial assets. Therefore, the true passive indexer would simply buy and hold the GFAP and take the aggregate market return as opposed to trying to beat what that portfolio can potentially return. If you choose an asset allocation that deviates from this weighting then you are, by definition, doing what “active” investors engage in by trying to pick assets in an allocation that is superior than the global index.
Ironically, almost all “passive” index funds run by Vanguard and other firms that advocate “passive” indexing are actually deviations from the market cap weighting of the GFAP. That is, they are inexpensive, but actively allocated deviations from the GFAP. There’s nothing “passive” about this except that they’re not as active or expensive as the dart throwing monkeys that their research often strawmans (see this prominent indexing “research” for instance). This is why we often see “passive” index funds underperform the GFAP – they’re nothing more than inexpensive actively chosen deviations from the GFAP.
We should be clear about costs – costs matter. There’s no doubt that John Bogle was right about his cost matters hypothesis. But the way you go about choosing your allocation will be a far more important driver in your future returns than costs – especially in a world where asset allocation has become so inexpensive. I’ve called this the “Allocation Matters Most Hypothesis”. Interestingly, we can actually prove that the GFAP return is often an inferior asset allocation by studying Vanguard’s own actively allocated funds.
Over the course of the last 40 years bonds have generated tremendous returns. But the GFAP, which is just an ex-post response to the market’s allocations, had just a 37% bond market weight relative to the 63% equity market weighting in 1970. If you’d followed this truly “passive” allocation until today you would have generated a 9.65% annualized return with a standard deviation of 12.11, Sharpe Ratio of 0.43 and a Sortino of 0.81.* Not bad. But Vanguards own actively chosen allocations beat this allocation on a risk adjusted and nominal basis!
Over the same period the Vanguard Wellesley fund, one of their oldest funds (which overweights bonds on average), generated a 9.96% CAGR, a 9.05 standard deviation, a Sharpe Ratio of 0.57 and a Sortino Ratio of 1.35. The Wellesley fund’s active deviation from the global market cap weighting “beat the market”. Of course, the Wellesley Fund costs 0.26% per year but even with that small fee the nominal AND risk adjusted returns were superior than the truly passive index before any fees. In other words, by constructing a fund that actively deviates from the global market cap weighting of outstanding financial assets Vanguard was able to construct a fund that defies the firm’s own logic.
The cost matters hypothesis is important. But the allocation matters most hypothesis is even more important.
* Interestingly, if you’d chosen not to rebalance and let the portfolio evolve with the naturally occurring cap weightings you would have generated a lower risk adjusted return of just 0.39 Sharpe and 0.69 Sortino Ratio.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.