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Popular Index Funds Perform Poorly

Index proponents have been particularly enthusiastic about Vanguard funds, which have received huge inflows. But Vanguard's best performers have been its actively managed funds. Of the 23 Vanguard active stock funds with 10-year records, 16 have outperformed their benchmarks. In many cases, the active funds have been clearly superior to the competing Vanguard index funds. During the past decade, Vanguard Capital Opportunity (VHCOX), a large growth fund, returned 6.7% annually, while Vanguard Growth Index (VIGRX) only rose 3.7%. In the same period, Vanguard Equity Income (VEIPX), a large value fund, climbed 4.9%, while Vanguard Value Index (VIVAX) gained 3.4%.

The success of the Vanguard active funds underlines the importance of low expense ratios. Expenses are the single most powerful predictor of future returns. On average, funds with low expense ratios beat those with high expense ratios. This is true whether the funds are passive or active. In Vanguard's case, the expense ratios of the active funds are extremely low and about the same as the figures for index funds. That has made it easy for Vanguard's adept active managers to top competing passive portfolios.

A few index funds charge small fees of less than 0.15%, and the funds can be sound investments. But the average index fund has an expense ratio of 0.62%. Many top active funds have fees that are comparable to the index average. For example, Vanguard Health Care (VGHCX), an active fund, has an expense ratio of 0.36%, while iShares Dow Jones U.S. Healthcare ETF (IYH), which tracks an index, charges 0.48%. So odds are that the Vanguard fund will outdo the ETF in the future.

Index proponents remain unimpressed with the success of top active funds like Vanguard's and say there is no good way to pick active funds. As the boilerplate says, past performance does not guarantee future results. But there are sensible ways to pick active funds. Academic studies have shown that Sharpe ratios can provide some guidance. Instead of looking at only performance, the Sharpe ratio considers risk-adjusted returns, or how much return a fund delivered considering the risk that it took. The Sharpe system penalizes high-risk funds that jump around erratically and can record big losses.

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