Vanguard or T. Rowe Price Funds: Actively Managed vs. Index Funds

Blogger pf at My Personal Finance Odyssey reviewed his investments in T. Rowe Price funds. He gathered last 5 years’ performance numbers for the T. Rowe Price funds he invested in and the performance numbers for similar funds by Vanguard. His analysis showed that many T. Rowe Price funds had better returns than the comparable Vanguard funds.

“Amazingly, the T Rowe Price funds fared better than I thought.  Although they clearly have higher expense ratios, I feel that is was often rewarded with superior returns.”

Because the performance numbers are after the expenses are taken out, the differences in expense ratios are already accounted for. Having a lower expense doesn’t mean a lot if the performance is also lower. pf’s analysis showed that in the last 5 years, many T. Rowe Price funds earned much more than the extra fees they charged. Then how come many people recommend Vanguard funds? Just for the low expenses? Isn’t that penny wise pound foolish if you are getting lower returns with low expenses? Naturally, pf wanted to know if he’s better off staying with T. Rowe Price funds or switching to Vanguard funds.

The question seems simple, but the answer is not. This is a difficult decision, no matter how much data you collect and how much calculation you do.

The first question is “Did T. Rowe Price funds beat Vanguard funds in the last 5 years?” You’ve gathered the performance data for each fund. Next you will have to weight-average them with your own allocation to each. Then it’s still only going to show the result for money invested at the beginning of the 5-year period. What about the money added during the period? You have to factor those in because the outperformance may have come at a time when you had only a relatively small amount invested. What about taxes (if your money is in taxable accounts)?

Let’s say you’ve done all those calculations and they showed that you would’ve been better off in T. Rowe Price funds in the last 5 years. The next question is “How did T. Rowe Price funds achieve better returns?” Was it because they took on more risk? If so, was the higher risk worth it? Could the higher risk have gone the other way? Was it because the T. Rowe Price managers had better skills or were they simply lucky?

After you knew who won and why, there’s still the question of who will win going forward. That’s what you want to know. If T. Rowe Price funds won in the last 5 years, will they win again in the next 5, 10, or 30 years? If they took on higher risk and won, will the higher risk lead you the other way? If the T. Rowe Price managers were lucky, will they continue to be lucky? If the managers had better skills, will they become unlucky despite better skills?

This line of thought applies to any actively managed funds, not just T. Rowe Price. Substitute T. Rowe Price with any other actively managed funds and you will have the same analysis.

Whichever way you go, actively managed or index funds, you will have to have a bit of faith. If you go with index funds, you must give up dreams of having better than market returns. You must believe that market returns are “good enough” and focus your energy elsewhere — earning more, investing more, and enjoying more. If you go with actively managed funds, you must believe that (1) the managers are skillful, not just lucky; (2) they are not taking more risks; (3) they will not be unlucky; and (4) their value-add will exceed their higher expenses.

Although I invest in Vanguard index funds, I don’t dismiss skills. Some managers are more skillful than others. But it’s very difficult to distinguish chance from skills. Unskillful people can get lucky. Skillful people can get unlucky. The records of identifying the skillful managers and keeping them from becoming unlucky are not that great.

I used to work in the fields of investment consulting. The company I worked for had full time consultants like me selecting investment managers and monitoring their performance for pension plans. We subscribed to performance databases, used all sorts of fancy tools, and produced all sorts of fancy tables and charts on nice glossy paper bound between nice covers. In the end sometimes we chose good managers and sometimes not so good. On average I can’t say for sure we did better than the market on a risk-adjusted basis because risk is very hard to measure. However no matter how we did, the clients happily paid our fees because they wanted to have someone working for them. We couldn’t charge them the fees if we simply put them into index funds because they could’ve easily done that themselves.

I no longer have access to the performance databases and those fancy tools. I’m not sure if all those work produced any better results anyway, other than looking busy doing something. For my personal investing, I just want to avoid taking the chances because the chances of outperforming the market are not that great. I  accept whatever the market gives to me and that’s good enough for me.

I don’t blame anybody wanting to do better though. People always want to do better. Whether you will actually do better is an entirely different question. As long as you don’t do something crazy, there is a reasonable chance, say 30%, for doing better. I just chose not to take that chance. If you decide to take the chance, and you hit the 30% side, you will be rewarded with higher returns. Just remember though you have a higher chance for doing worse than doing better.