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

Indexed strategies benefit clients and advisors • The difficulty of active management • Why indexing works • Indexing’s role in a client portfolio > 2

On average, active management has not added value Relative performance of actively managed funds • Actively managed funds have Value Blend Growth Developed Emerging Mkts Mkts 56% 83% 73% underperformed across asset Large 56% 64% 0.08% (1.38%) (1.04%) and sub-asset classes 99% 96% 98% 0.34% (0.27%) Medium (2.63)% (2.51%) (3.75%) • Generally due to high costs and 84% 93% 76% Small reasonably efficient markets (1.34%) (3.11)% (0.66)% Government Corporate GNMA High-Yield • Investors seeking 94% 99% 100% 93% Short outperformance have been (.79)% (1.61%) (0.72%) (1.02%) 80% 91% disappointed as expectations Intermediate (0.27)% (0.83)% have not been met % underperforming benchmark - adjusted for survivorship bias Median fund excess return 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. 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. > 3

And among those that do add value, leadership is quick to change Risk-Adjusted Rank in Subsequent Non-Overlapping Five Year Period (% of funds) Return Rank Ending Dec 2004 Highest Lowest 5-Years High Medium Low Missing Total Ending Dec 1999 Quintile Quintile 64% chance for top Highest Quintile (1) 7.1% 9.8% 19.3% 22.0% 31.5% 10.4% 100.0% quintile fund to underperform in High (2) 11.5% 16.7% 19.4% 26.4% 18.8% 7.3% 100.0% subsequent 5 years 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% Risk-Adjusted Rank in 2nd Subsequent Non-Overlapping Five Year Period (% of funds) Return Rank Ending Dec 2009 5-Years Highest Lowest 55% chance for top Ending Dec 1999 Quintile High Medium Low Quintile Missing Total quintile fund to Highest Quintile (1) 18.4% 12.8% 12.2% 16.9% 15.7% 24.0% 100.0% underperform in next 5 High (2) 17.9% 14.8% 13.9% 12.7% 14.5% 26.1% 100.0% years as well 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% 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. > 4

This can lead to portfolios that may not live up to expectations Portfolios of actively managed funds can increase risk and/or lower returns 8.5 US Stock Market 8.0 Average active US equity portfolio 7.5 Annual Return (%) US Bond Market 7.0 6.5 International Stock Market Average active 6.0 international stock portfolio 5.5 Average active bond 5.0 portfolio 4.5 4.0 0 5 10 15 20 25 Annual Volatility (%) 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 . > 5

Why does indexing work? • The zero-sum game • Costs • Portfolio and market dynamics > 6

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) > 7 Source: Vanguard Investment Strategy Group

Indexed strategies have a built in cost advantage Index funds generally offer lower costs across asset and sub asset classes Actively Managed Index Funds Difference Funds Large Cap US Equity 86 bps 19 bps 68 bps 82 bps Mid Cap US Equity 106 bps 24 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 Source: Vanguard calculations using data from Morningstar > 8 Expense ratios are asset weighted. Data as of December 31, 2009.

The zero sum game is difficult to overcome for the average actively managed equity fund Annualized Excess Returns Versus U.S. Stock Market: As of 12/31/2009 Dow Jones U.S. Total 400 Stock Market Index 350 10-Years: 1279 Worse (41%) * 10-Years: 1845 Better (59%) Number of Funds 300 15-Years: 748 Worse (61%) * 15-Years: 472 Better (39%) 20-Years: 235 Better (48%) 250 20-Years: 256 Worse (52%) * 200 10 year 15 year 150 20 year 100 50 0 <–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 • 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 > 9 underperforming funds fall to 64% worse for 10-years, 76% worse for 15-years, and 71% worse for 20-years.