Vanguard Outperforms Index Mutual Funds

Vanguard's active mutual funds have beaten the performance of its index funds, upon which the company was built.
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NEW YORK (TheStreet) -- Mutual-fund investors, fed up with big losses during the stock-market downturn, have been dumping their actively managed funds and shifting to index funds. The move to indexing is especially pronounced at Vanguard Group, which built its business model on index mutual funds.

During the past 12 months, assets have poured into Vanguard index funds. Inflows have totaled $11.2 billion for

Vanguard Total Stock Market Index

(VTSMX) - Get Report

and $2.1 billion for

Vanguard Total International Stock Index

(VGTSX) - Get Report

, according to Morningstar. At the same time, assets have left many active funds. Outflows reached $1.1 billion for

Vanguard Strategic Equity

(VSEQX) - Get Report

and $1.5 billion for

Vanguard Windsor II

(VWNFX) - Get Report

.

Buying index funds can be a wise move, but Vanguard investors shouldn't be quick to dismiss active funds. During the past decade, most Vanguard active funds outperformed comparable index funds.

To assess the performance of active funds, I looked at the 19 active Vanguard equity funds with 10-year records. Of those, 13 had outdone their benchmarks. In cases where Vanguard offered an index fund and an active fund in the same category, it usually paid to own the active fund.

Consider that

Vanguard Equity Income

(VEIPX) - Get Report

, a large-value fund, returned 4.2% annually for the past decade, while

Vanguard Value Index

(VIVAX) - Get Report

, a comparable index fund, returned only 1.9%. Despite its superior record, the active fund had outflows of $69 million in the past 12 months, while the index portfolio had inflows of $306 million.

Other active large-value funds that topped the index fund by wide margins include

Vanguard Windsor

(VWNDX) - Get Report

and Vanguard Windsor II. In the large-growth category,

Vanguard Growth Index

(VIGRX) - Get Report

lost 2.7% annually, while actively managed

Vanguard Capital Opportunity

(VHCOX) - Get Report

topped the index fund by 6 percentage points, and

Vanguard Morgan Growth

(VMRGX)

won by a margin of 1 percentage point.

Why have the Vanguard active funds excelled? For starters, Vanguard has long had a sound track record for picking active managers. The company favors managers that produce steady results by following consistent disciplines. And when the managers have failed to produce solid results, Vanguard replaced them with better choices.

Besides looking for consistent managers, Vanguard has famously imposed low fees on its active funds -- almost the same as what it charges for index funds. Vanguard Windsor II has an expense ratio of 0.38%, compared to 0.26% for Vanguard Value Index. This is in contrast to most other fund companies which charge high fees on active funds. The average domestic equity fund has an expense ratio of 1.37%.

Because of high fees, most active funds lag their benchmarks over the long term, says John Rekenthaler, Morningstar's vice president for research. Setting aside fees and trading costs, the average active manager outperforms the benchmarks, Rekenthaler says. At Vanguard, the fees are so low that active managers have a relatively easy time topping their benchmarks.

Make no mistake, market conditions have helped Vanguard managers beat their benchmarks in recent years. Active funds tend to excel during harsh times -- and the past decade was filled with harsh years.

To appreciate why active funds tend to outperform in downturns, consider

Vanguard 500 Index

(VFINX) - Get Report

, the granddaddy of all S&P 500 index funds, which lost 0.7% annually and trailed 58% of large-blend funds during the past decade. While S&P 500 funds offer a concentrated dose of large-cap stocks, actively managed large-cap funds tend to be somewhat mixed, holding cash and mid-cap stocks along with blue chips.

During periods when big stocks dominate, as happened in the late 1990s, the highly focused S&P 500 tends to outdo active funds. But when big stocks sag, as occurred in the past decade, the index fund will lag more diversified actively managed funds.

If big stocks outperform in the next decade, as some strategists expect, the S&P 500 fund may once again beat most active managers. But with their low fees and steady discipline, the Vanguard active funds should continue delivering competitive results.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.