Garrett L. Harbron, J.D., CFA, CFP®; Daren R. Roberts; and James J. Rowley Jr.

, CFA
Vanguard Research June 2016
■ Due to governmental regulatory changes, the introduction of exchange-traded funds
(ETFs), and a growing awareness of the benefits of low-cost investing, the growth
of index investing has become a global trend over the last several years, with a
large
and growing investor base.
■ This paper discusses why we expect index investing to continue to be successful
over
the long term—a rationale grounded in the zero-sum game, the effect of costs, and
the challenge of obtaining persistent outperformance.
■ We examine how indexing performs in a variety of circumstances, including diverse
time periods and market cycles, and we provide investors with points to consider
when evaluating different investment strategies.

Acknowledgments: The authors thank David J. Walker, of Vanguard’s Investment

Strategy Group, for his valuable
contributions to this paper. This paper is a revision of Vanguard research first
published in 2004 as The Case for
Indexing by Nelson Wicas and Christopher B. Philips, updated in succeeding years by
Mr. Philips and other co-authors.
The current authors acknowledge and thank Mr. Philips and Francis M. Kinniry Jr.
for their extensive contributions
and original research on this topic.
Note: This research paper was written in the context of the U.S. market, and it may
contain data and analysis specific to the United States. All figures are
in U.S. dollars.
For Qualified and Institutional Investors only. Not for public distribution.

Index investing1 was first made broadly available to U.S.

investors with the launch of the first index mutual fund in
1976. Since then, low-cost index investing has proven to
be a successful investment strategy over the long term,
outperforming the majority of active managers across
markets and asset styles (S&P Dow Jones Indices, 2015).
In part because of this long-term outperformance, index
investing has seen exponential growth among investors,
particularly in the United States, and especially since the
global financial crisis of 2007–2009. In recent years,
governmental regulatory changes, the introduction of
indexed ETFs, and a growing awareness of the benefits
of low-cost investing in multiple world markets have
made index investing a global trend. This paper reviews
the conceptual and theoretical underpinnings
of index investing’s ascendancy (along with supporting
quantitative data) and discusses why we expect index
investing to continue to be successful and to increase
in popularity in the foreseeable future.
A market-capitalization-weighted indexed investment
strategy—via a mutual fund or an ETF, for example—
seeks to track the returns of a market or market
segment with minimal expected deviations (and, by
extension, no positive excess return) before costs,
by assembling a portfolio that invests in the securities,
or a sampling of the securities, that compose the
market. In contrast, actively managed funds seek to
achieve a return or risk level that differs from that of
a market-cap-weighted benchmark. Any strategy, in fact,
that aims to differentiate itself from a market-cap-weighted
benchmark (e.g., “alternative indexing,” “smart beta” or
“factor strategies”) is, in our view, active management
and should be evaluated based on the success of
the differentiation.2
This paper presents the case for low-cost index-fund
investing by reviewing the main drivers of its efficacy.
These include the zero-sum game theory, the effect of
costs, and the difficulty of finding persistent outperformance
among active managers. In addition, we review
circumstances under which this case may appear less
or more compelling than theory would suggest, and
we provide suggestions for selecting an active manager
for investors who still prefer active management or for
whom no viable low-cost indexed option is available.

Notes on risk
Notes about risk and performance data: Investments are subject to market risk,
including the possible loss of the money
you invest. Past performance is no guarantee of future returns. Bond funds are
subject to the risk that an issuer will fail
to make payments on time, and that bond prices will decline because of rising
interest rates or negative perceptions of
an issuer’s ability to make payments. Investments in stocks issued by non-U.S.
companies are subject to risks including
country/regional risk, which is the chance that political upheaval, financial
troubles, or natural disasters will adversely
affect the value of securities issued by companies in foreign countries or regions;
and currency risk, which is the chance
that the value of a foreign investment, measured in U.S. dollars, will decrease
because of unfavorable changes in
currency exchange rates. Stocks of companies based in emerging markets are subject
to national and regional political
and economic risks and to the risk of currency fluctuations. These risks are
especially high in emerging markets.
Funds that concentrate on a relatively narrow market sector face the risk of higher
share-price volatility. Prices of midand
small-cap stocks often fluctuate more than those of large-company stocks. U.S.
government backing of Treasury
or agency securities applies only to the underlying securities and does not prevent
share-price fluctuations. Because
high-yield bonds are considered speculative, investors should be prepared to assume
a substantially greater level of
credit risk than with other types of bonds. Diversification does not ensure a
profit or protect against a loss in a declining
market. Performance data shown represent past performance, which is not a guarantee
of future results. Note that
hypothetical illustrations are not exact representations of any particular
investment, as you cannot invest directly in
an index or fund-group average.

1 Throughout this paper, we use the term index investing to refer to a passive,
broadly diversified, market-capitalization-weighted strategy. Also for purposes of
this discussion,
we consider any strategy that is not market-cap-weighted to be an active strategy.
2 See Pappas and Dickson (2015), for an introduction to factor strategies. Chow et
al. (2011) explained how various alternatively weighted index strategies
outperformed marketcap-weighted
strategies largely on the basis of factors.
Zero-sum game theory
The central concept underlying the case for index-fund
investing is that of the zero-sum game. This theory
states that, at any given time, the market consists of
the cumulative holdings of all investors, and that the
aggregate market return is equal to the asset-weighted
return of all market participants. Since the market return
represents the average return of all investors, for each
position that outperforms the market, there must be a
position that underperforms the market by the same
amount, such that, in aggregate, the excess return of all
invested assets equals zero.3 Note that this concept does
not depend on any degree of market efficiency; the zerosum
game applies to markets thought to be less efficient
(such as small-cap and emerging market equities) as
readily as to those widely regarded as efficient (Waring
and Siegel, 2005).
Figure 1 illustrates the concept of the zero-sum game.
The returns of the holdings in a market form a bell curve,
with a distribution of returns around the mean, which
is the market return.
It may seem counterintuitive that the zero-sum game
would apply in inefficient markets, because, by definition,
an inefficient market will have more price and informational
inefficiencies and, therefore, more opportunities for
outperformance. Although this may be true to a certain
extent, it is important to remember that for every profitable
trade an investor makes, (an)other investor(s) must take
the opposite side of that trade and incur an equal loss. This
holds true regardless of whether the security in question is
mispriced or not. For the same reason, the zero-sum game
must apply regardless of market direction, including bear
markets, where active management is often thought to
have an advantage. In a bear market, if a manager is
selling out of an investment to position the portfolio
more defensively, another or others must take the other
side of that trade, and the zero-sum game still applies.
The same logic applies in any other market, as well.
Some investors may still find active management
appealing, as it seemingly would provide an even-odds
chance of successfully outperforming. As we discuss
in the next section, though, the costs of investing make
outperforming the market significantly more difficult
than the gross-return distribution would imply.
Effect of costs
The zero-sum game discussed here describes a
theoretical cost-free market. In reality, however, investors
are subject to costs to participate in the market. These
costs include management fees, bid-ask spreads,
administrative costs, commissions, market impact, and,
where applicable, taxes—all of which can be significant
and reduce investors’ net returns over time. The
aggregate result of these costs shifts the return
distribution to the left.

Figure 1. Market participants’ asset-weighted returns

form a bell curve around market’s return

Figure 2 shows two different investments compared to

the market. The first investment is an investment with
low costs, represented by the red line. The second
investment is a high-cost investment, represented by the
blue line. As the figure shows, although both investments
move the return curve to the left—meaning fewer assets
outperform—the high-cost investment moves the return
curve much farther to the left, making outperformance
relative to both the market and the low-cost investment
much less likely. In other words, after accounting for
costs, the aggregate performance of investors is less
than zero sum, and as costs increase, the performance
deficit becomes larger.
This performance deficit also changes the risk–return
calculus of those seeking to outperform the market.
We previously noted that an investor may find active
management attractive because it theoretically provides
an even chance at outperforming the market. Once we
account for costs, however, underperformance becomes
more likely than outperformance. As costs increase, both
the odds and magnitude of underperformance increase
until significant underperformance becomes as likely,
or more likely, than even minor outperformance.
Figure 3 illustrates the zero-sum game on an after-cost
basis by showing the distribution of excess returns of
domestic equity funds (Figure 3a) and fixed income funds
(Figure 3b), net of fees. Note that for both asset classes,
returns are skewed to the left of the prospectus benchmark,
which represents zero excess returns. Negative
excess returns tend to be more common, and of higher
magnitude, than positive excess returns, especially once
merged and closed funds are considered.4 Thus, as
predicted by the zero-sum game theory, outperformance
tends to be both less likely and of lower magnitude
than underperformance, once costs are considered.
This begs the question of how investors can reduce the
chances of underperforming their benchmark. Considerable
evidence supports the view that the odds of outperforming
a majority of similar investors increase if investors simply
seek the lowest possible cost for a given strategy. For
example, Financial Research Corporation (2002) evaluated

the predictive value of different fund metrics, including a

fund’s past performance, Morningstar rating, alpha, and
beta. In the study, a fund’s expense ratio was the most
reliable predictor of its future performance, with low-cost
funds delivering above-average performance relative to the
funds in their peer group in all of the periods examined.
Likewise, Morningstar performed a similar analysis across
its universe of funds and found that, regardless of fund
type, low expense ratios were the best predictors of
future relative outperformance (Kinnel, 2010).
This negative correlation between costs and excess
return is not unique to active managers. Rowley and
Kwon (2015) looked at several variables across index
funds and ETFs, including expense ratio, turnover,
tracking error, assets under management, weighting
methodology, and active share, and found that expense
ratio was the most dominant variable in explaining an
index fund’s excess return.
Notes: Past performance is no guarantee of future results. Charts a. and b. display
distribution of funds’ excess returns relative to their prospectus benchmarks for
the 15 years
ended December 31, 2015.
Sources: Vanguard calculations, based on data from Morningstar, Inc.

To quantify the impact of costs on net returns, we

charted managers’ excess returns as a function of their
expense ratios across various categories of funds over
a ten-year period. Figure 4 shows that higher expense
ratios are generally associated with lower excess returns.
The blue line in each style box in the figure represents
the simple regression line and signifies the trend across
all funds for each category. For investors, the clear
implication is that by focusing on low-cost funds (both
active and passive), the probability of outperforming
higher-cost portfolios increases.
6
Figure 4. Higher expense ratios were associated with lower excess returns for U.S.
funds:
As of December 31, 2015
a. U.S. equity funds

Notes to charts a. and b.: Past performance is no guarantee of future results. All
data as of December 31, 2015. Index funds are shown in red. Each plotted point
represents
a U.S. equity or bond mutual fund within the specific identified Morningstar size,
style, and asset group. Each fund is plotted to represent the relationship of its
expense ratio
(x-axis) versus its ten-year annualized excess return relative to its stated
benchmark (y-axis). The straight line represents the linear regression, or the
best-fit trend line—that is,
the general relationship of expenses to returns within each asset group. The scales
are standardized to show the slopes’ relationship to each other, with expenses
ranging from
0% to 3% and returns ranging from –15% to 15% for equities and from –5% to 5% for
fixed income. Some funds’ expense ratios and returns go beyond the scales and are
not shown.
Sources: Vanguard calculations, based on data from Morningstar, Inc.

Costs play a crucial role in investor success. Whether

invested in an actively managed fund or an index fund,
each basis point an investor pays in costs is a basis
point less an investor receives in returns. Since excess
returns are a zero-sum game, as cost drag increases,
the likelihood that the manager will be able to overcome
this drag diminishes. As such, most investors’ best
chance at maximizing net returns over the long term
lies in minimizing these costs. In most markets, lowcost
index funds have a significant cost advantage
over actively managed funds. Therefore, we believe
that most investors are best served by investing
in low-cost index funds over their higher-priced,
actively managed counterparts.
Persistent outperformance is scarce
For those investors pursuing an actively managed
strategy, the critical question becomes: Which fund
will outperform? Most investors approach this question
by selecting a winner from the past. Investors cannot
profit from a manager’s past success, however, so it
is important to ask, Does a winning manager’s past
performance persist into the future? Academics have
long studied whether past performance can accurately
predict future performance. About 50 years ago, Sharpe
(1966) and Jensen (1968) found limited to no persistence.
Three decades later, Carhart (1997) reported no evidence
of persistence in fund outperformance after adjusting
for both the well-known Fama-French (1993) three-factor
model as well as momentum. More recently, Fama and
French (2010) reported results of a separate 22-year
study suggesting that it is extremely difficult for an
actively managed investment fund to outperform
its benchmark regularly.
To test if active managers’ performance has persisted, we
looked at two separate, sequential, non-overlapping fiveyear
periods. First, we ranked the funds by performance
quintile in the first five-year period, with the top 20% of
funds going into the first quintile, the second 20% into the
second quintile, and so on. Second, we sorted those funds
by performance quintile according to their performance in
the second five-year period. To the second five-year period,
however, we added a sixth category: funds that were either
liquidated or merged during that period. We then compared
the results. If managers were able to provide consistently
high performance, we would expect to see the majority of
first-quintile funds remaining in the first quintile. Absent
that ability, we would expect to find those managers
approximately equally divided among the performance
quintiles. Figure 5 reveals that these managers fared hardly
better than we would expect from a random distribution.
It is interesting to note that, once we accounted for closed
and merged funds, persistence was actually stronger
among the underperforming managers than those that
outperformed. These findings were consistent across all
asset classes and all markets we studied globally. From
this, we concluded that consistent outperformance is very
difficult to achieve. This is not to say that there are not
periods when active management outperforms, or that no
active managers do so regularly. Only that, on average and
over time, active managers as a group fail to outperform;
and even though some individual managers may be able
to generate consistent outperformance, those active
managers are extremely rare

Figure 5. Actively managed domestic funds failed to show persistent outperformance

Subsequent five-year excess return ranking, through December 31, 2015
Initial excess return
quintile, five years Number Highest 2nd 3rd 4th Lowest Merged/
ended December 31, 2010 of funds quintile quintile quintile quintile quintile
liquidated Total
1st quintile 1,100 16.2% 16.3% 15.6% 15.3% 24.1% 12.5% 100.0%
2nd quintile 1,111 15.2 16.1 18.0 17.6 15.8 17.3 100.0
3rd quintile 1,105 12.8 15.5 14.8 16.9 15.3 24.8 100.0
4th quintile 1,105 15.5 16.2 16.0 11.6 10.5 30.2 100.0
5th quintile 1,105 15.1 11.4 10.6 13.8 9.4 39.7 100.0
Notes: The “excess return ranking” columns rank all active U.S. equity funds within
each of the nine Morningstar style categories based on their excess returns
relative to their stated
benchmarks during the five-year period ended December 31, 2010. The remaining,
shaded columns show how funds in each quintile performed over the subsequent five
years through 2015.
Sources: Vanguard and Morningstar, Inc.

When the case for low-cost index fund investing

can seem less or more compelling
For the reasons already discussed, we expect the case
for low-cost index fund investing to hold over the long
term. Like any investment strategy, however, the realworld
application of index investing can be more complex
than the theory would suggest. This is especially true
when attempting to measure indexing’s track record
versus that of active management. Various circumstances,
which we discuss next, can result in data that at times
show active management outperforming indexing while,
at other times, show indexing outperforming active
management by more than would be expected. As a
result, the case for low-cost index fund investing can
appear either less or more compelling than the theory
would indicate. The subsections following address
some of these circumstances.
Survivorship bias can skew results
Survivorship bias is introduced when funds are merged
into other funds or liquidated, and so are not represented
throughout the full time period examined. Because such
funds tend to be underperformers (see the accompanying
box titled “Merged and liquidated funds have tended
to be underperformers” and Figure 6, on page 10),
this skews the average results upward for the surviving
funds, causing them to appear to perform better
relative to a benchmark.5

5 For a more detailed discussion of the underperformance of closed funds, see

Schlanger and Philips (2013).

Merged and liquidated funds have tended to be underperformers

To test the assumption that closed funds underperformed,
we evaluated the performance of all domestic funds
identified by Morningstar as either being liquidated or
merged into another fund. We reviewed returns of those
funds from January 2001 until the month-end before each
fund’s closing date (the results are shown in Figure 6,
below). Given that in the majority of fund categories more
than 75% of the funds examined trailed their benchmarks
before being closed, we found the assumption that merged
and liquidated funds underperformed to be reasonable.
Figure 6. Dead funds showed underperformance versus style benchmark from January 1,
2001, to closing date

Notes: Chart displays cumulative annualized performance of U.S. equity funds that
were merged or liquidated within this study’s sample, relative to the
representative
benchmark for each Morningstar style category. We measured performance starting
from January 1, 2001, through the fund’s month-end before the fund was merged or
liquidated. Figure displays the middle-50% distribution of these funds’ returns
before their closure. See appendix, page 18, for benchmarks used for each
Morningstar
style category.
Sources: Vanguard calculations, based on data from Morningstar, Inc., Standard &
Poor’s, MSCI, CRSP, and Barclays.

However, the average experience of investors—some of

whom invested in the underperforming fund before it was
liquidated or merged—may be much different. Figure 7
shows the impact of survivorship bias on the apparent
relative performance of actively managed funds versus
both their prospectus and style benchmarks. In either
case, a majority of active funds underperformed
regardless of the asset class or style we examined, and
this underperformance became more pronounced as
the time period lengthened and survivorship bias was
accounted for. Thus, it is critical to adjust for survivorship
bias when comparing the performance of active funds to
their benchmarks, especially over longer time periods.

Figure 7. Percentage of actively managed mutual funds that underperformed versus

their benchmarks:
Periods ended December 31, 2015
a. Versus fund prospectus

Notes: Data reflect periods ended December 31, 2015. Fund style categories provided
by Morningstar; benchmarks reflect those identified in each fund’s prospectus.
“Dead” funds are those that were merged or liquidated during the period.
Sources: Vanguard calculations, based on data from Morningstar, Inc.

Figure 7 (Continued). Percentage of actively managed mutual funds that

underperformed versus their benchmarks:
Periods ended December 31, 2015
b. Versus representative ‘style benchmark’

Notes: Past performance is no guarantee of future results. Benchmark comparative

indexes represent unmanaged or average returns on various financial assets, which
can
be compared with funds’ total returns for the purpose of measuring relative
performance. Data reflect periods ended December 31, 2015. Fund style categories
provided by
Morningstar. See appendix, page 18, for benchmarks used for each Morningstar style
category. “Dead” funds are those that were merged or liquidated during the period.
Sources: Vanguard calculations, based on data from Morningstar, Inc., MSCI, CRSP,
Standard & Poor’s, and Barclays.

Mutual funds are not the entire market

Another factor that can complicate the analysis of realworld
results is that mutual funds, which are used as a
proxy for the market in most studies (including this one),
do not represent the entire market and therefore do not
capture the entire zero-sum game. Mutual funds are
typically used in financial market research because their
data tend to be readily available and because, in many
markets, mutual fund assets represent a reasonable
sampling of the overall market. It is important to note,
however, that mutual funds are merely a market
sampling. In cases where mutual funds constitute a
relatively smaller portion of the market being examined,
the sample size studied will be that much smaller,
and the results more likely to be skewed. Depending
on the direction of the skew, this could lead to either
a less favorable or a more favorable result for active
managers overall.
Portfolio exposures can make relative performance
more difficult to measure
Differences in portfolio exposures versus a benchmark
or broader market can also make relative performance
difficult to measure. Benchmarks are selected by fund
managers on an ex ante basis, and do not always reflect
the style in which the portfolio is actually managed. For
example, during a period in which small- and mid-cap
equities are outperforming, a large-cap manager may hold
some of these stocks in the portfolio to increase returns
(Thatcher, 2009). Similarly, managers may maintain an
over/underexposure to certain factors (e.g., size, style,
etc.) for the same reason. These portfolio tilts can cause
the portfolio to either outperform or underperform when
measured against the fund’s stated benchmark or the
broad market, depending on whether the manager’s tilts
are in or out of favor during the period being examined.
Over a full market or factor cycle, however, we would
expect the performance effects of these tilts to cancel
out and the zero-sum game to be restored.
Short time periods can understate
the advantage of low-cost indexing
Time is an important factor in investing. Transient
forces such as market cycles and simple luck can more
significantly affect a fund’s returns over shorter time
periods. These short-term effects can mask the relative
benefits of low-cost index funds versus active funds in
two main respects: the performance advantage conferred
on index funds over the longer term by their generally
lower costs; and the lack of persistent outperformance
among actively managed funds.
A short reporting period reduces low-cost index funds’
performance advantage because the impact of their
lower costs compounds over time. For example, a
50-basis-point difference in fees between a low-cost
and a higher-cost fund may not greatly affect the funds’
performance over the course of a single year; however,
that same fee differential compounded over longer time
periods can make a significant difference in the two
funds’ overall performance.
Time also has a significant impact on the application
of the zero-sum game. In any given year, the zero-sum
game states that there will be some population of
funds that outperforms the market. As the time period
examined becomes longer, however, the effects of luck
and market cyclicality tend to cancel out, reducing the
number of funds that outperform. Market cyclicality is an
important factor in the lack of persistent outperformance
as investment styles and market sectors go in and out
of favor, as noted earlier.

This concept is illustrated in Figure 8, which compares

the performance of domestic funds over rolling one- and
ten-year periods to that of their benchmarks. As the figure
shows, active funds were much less likely to outperform
over longer periods compared with shorter periods; this
was especially true when merged and liquidated funds
were included in the analysis. Thus, as the time period
examined became longer, the population of funds that
consistently outperformed tended to shrink, ultimately
becoming very small.
Low-cost indexing—a simple solution
One of the simplest ways for investors to gain market
exposure with minimal costs is through a low-cost index
fund or ETF. Index funds seek to provide exposure to a
broad market or a segment of the market through varying
degrees of index replication ranging from full replication
(in which every security in the index is held) to synthetic
replication (in which index exposure is obtained through
the use of derivatives). Regardless of the replication
14
Figure 8. Percentage of active U.S. equity funds underperforming over rolling
periods versus
prospectus benchmarks

Notes: Past performance is no guarantee of future results. Performance is

calculated relative to funds’ prospectus benchmarks. “Dead” funds are those that
were merged
or liquidated during the period.
Sources: Vanguard calculations, based on data from Morningstar, Inc.

method used, all index funds seek to track the target

market as closely as possible and, by extension, to
provide market returns to investors. This is an important
point and is why index funds, in general, are able to offer
investors market exposure at minimal cost. Index funds
do not attempt to outperform their market, as many
active managers do. As such, index funds do not require
the significant investment of resources necessary to find
and capitalize on opportunities for outperformance (such
as research, increased trading costs, etc.) and therefore
do not need to pass those costs onto their investors.
By avoiding these costs, index funds are generally able to
offer broad market exposure, with market returns at very
low cost relative to the cost of most actively managed
funds. Furthermore, because index funds do not seek
to outperform the market, they also do not face the
challenges of either persistent outperformance or of
beating the zero-sum game. In short, by accepting
market returns while keeping costs low, low-cost
index funds lower the hurdles that make successful
active management so difficult over the long term.
Although we believe that low-cost index funds offer
most investors their best chance at maximizing fund
returns over the long run, we acknowledge that some
investors want or need to pursue an active strategy. For
example, investors in some markets may have few lowcost,
domestic index funds available to them. For those
investors, or any investor choosing an active strategy,
low-cost, broadly diversified actively managed funds can
serve as a viable alternative to index funds, and in some
cases may prove superior to higher-cost index funds;
keep in mind that the performance advantage conferred
by low-cost funds is quickly eroded as costs increase.
Conclusion
Since its inception, low-cost index investing has proven
to be a successful investment strategy over the long
term, and has become increasingly popular with investors
globally. This paper has reviewed the conceptual and
theoretical underpinnings of index investing and has
discussed why we expect the strategy to continue to
be successful, and to continue to gain in popularity,
in the foreseeable future.
The zero-sum game, combined with the drag of costs on
performance and the lack of persistent outperformance,
creates a high hurdle for active managers in their attempts
to outperform the market. This hurdle grows over time
and can become insurmountable for the vast majority
of active managers. However, as we have discussed,
circumstances exist that may make the case for
low-cost indexing seem less or more compelling
in various situations.
This is not to say that a bright line necessarily exists
between actively managed funds and index funds. For
investors who wish to use active management, either
because of a desire to outperform or because of a lack
of low-cost index funds in their market, many of the
benefits of low-cost indexing can be achieved by selecting
low-cost, broadly diversified active managers. However,
the difficult task of finding a manager who consistently
outperforms, combined with the uncertainty that active
management can introduce into the portfolio, means
that, for most investors, we believe the best chance
of successfully investing over the long term lies in
low-cost, broadly diversified index funds.

--------------

Daniel W. Wallick; Brian R. Wimmer, CFA; Christos Tasopoulos; James Balsamo, CFA;
Joshua M. Hirt

■ How should an investor allocate across active and passive investments? It’s
a challenging decision with many components. In the absence of a structured
decision-making process, investors are left making arbitrary decisions based
on implicit assumptions.
■ In this paper, we provide a quantitative framework for active-passive decision-
making
and aim to shed light on those implicit assumptions by highlighting the explicit
attributes affecting the process. We employ a model using four key variables—
gross alpha expectation, cost, active risk, and active risk tolerance—to establish
active and passive investment allocation targets for a range of investor types.
■ Indexing is a valuable starting point for all investors, and many may index their
entire portfolio. But our analysis shows that for those who are comfortable with
the characteristics of active investments, an allocation to active can also be
a viable solution.

Introduction
Imagine for a moment that you live in a world with only
two fund options: a passively managed fund1 and an
actively managed fund2 with similar levels of volatility.
You, the investor, are trying to determine how to
structure your two-fund portfolio.
The expected relative return of the active fund is simply
a function of two variables—gross alpha expectation and
cost. If the resulting net relative performance (gross
alpha minus cost) is expected to be positive, the simple
choice would be to allocate 100% to the active fund. If,
on the other hand, the resulting net alpha of the active
fund is expected to be negative, the choice would be
equally straightforward—allocate 100% to the passive
fund. This approach results in a binary choice—either all
active or all passive.
It is this dynamic that is often at the heart of the activepassive
debate, which tends to focus on all-or-nothing
views and recommendations. Proponents of passive
investing point to research demonstrating that the
median active manager underperforms after costs and
that outperformers are difficult to recognize in advance.
Meanwhile, proponents of active investing argue that
despite the underperformance of the median active fund,
many active managers do still add value, and the impact
of possible outperformance can be significant. And so
the debate rages on.
We reject this basic, binary choice. Both active and
passive investments have potential benefits in a portfolio.
Passive funds offer low-cost benchmark tracking, leading
to a tight range of relative returns. Active funds offer the
potential for outperformance in exchange for a wider
range of relative returns (in other words, greater
uncertainty) and typically higher costs.3
With this in mind, let’s return to our original thought
exercise. But this time, in addition to gross alpha and cost,
let’s consider two more variables: active risk (defined as
the uncertainty of future manager performance) and active
risk tolerance (the degree to which an investor can tolerate
this uncertainty).4 Now we can consider a more nuanced
trade-off between active and passive by incorporating
an “uncertainty penalty” to our active expectations.
This can help balance the potential positive impact
of alpha expectations with the uncertainty of achieving
a favorable outcome.
We can then incorporate more details to help make our
decision. For example, would it be prudent to invest in
the active fund if it is expected to provide 0.10% net
annualized outperformance?
Some degree of uncertainty is inherent in any active
decision. Despite a possible positive relative return
expectation, there is still a chance that the manager
won’t achieve the expected outperformance. In this
case, the modest size of the potential reward may
not be substantial enough to justify a 100% allocation
to the active fund given its uncertainty.
But what about a 5% allocation to this fund as part
of an active-passive portfolio? What about 25%? How
does the level of active risk inherent in the fund affect
this decision? How does your own (or your organization’s,
or your client’s) tolerance for taking on active risk affect
it? And what if we increase or decrease the gross alpha
expectation or cost associated with investing in the fund?
These are the types of questions we consider in this paper.
We aim to assist the active-passive decision-making
process by enabling investors to think more deliberately
about their expectations and the risks they’re willing to
accept. Our framework makes these expectations explicit,
a valuable contribution to ongoing due diligence and
regular calibration of the conditions that justify a given
active-passive mix.

Notes on risk
Please remember that all investments involve some risk. Be aware that fluctuations
in the financial markets
and other factors may cause declines in the value of your account. There is no
guarantee that any particular asset
allocation or mix of funds will meet your investment objectives or provide you with
a given level of income.
All investing is subject to risk, including possible loss of principal.

1 The passive fund in the context of our paper is a market-cap-weighted index fund
in a single asset class—for example, a broad-based U.S. equity index fund.
2 The active fund in the context of our paper is a traditional actively managed
fund in the same sub-asset class as the passive fund—for example, a U.S. equity
active
fund that uses bottom-up security selection.
3 Active funds, on average, tend to have higher total expense ratios as well as
higher tax costs for those subject to tax. See Philips, Kinniry, Walker, Schlanger,
and Hirt (2015).
4 Active risk tolerance is defined as the willingness with which an investor would
take on active risk in return for an uncertain benefit of positive alpha. We’ll
talk
in more detail later about how this influences the active-passive decision-making
process.

For Institutional or Accredited Investor Use Only. Not For Public Distribution

The active-passive decision framework

The portfolio construction process begins with establishing
an appropriate strategic asset allocation. A secondary but
important decision is how to implement the asset class
and sub-asset class exposures determined in the first
step. It is at this point that specific investment products
are evaluated and the decision to allocate between active
and passive investments will be made. See Figure 1 for
an illustration of the hierarchy of portfolio decisions.
This paper offers a framework to enable investors to
more explicitly approach and evaluate the mix of active
and passive investments in their portfolios. It identifies
the key decision factors all investors are subject to
when determining a reasonable balance based on their
individual circumstances.5 It does not purport to promise
better returns but rather to offer a clear decision-making
process investors can use to establish a target allocation.
This framework can also be used with other strategies
such as factor investing. See Appendix B for more detail.
Prior Vanguard research has affirmed the active-passive
decision as a broad strategic decision rather than a
regional or time period-specific one. This differs from
the belief that active funds can best flourish in specific
market segments or time periods. We find that neither
the market segments nor the time of the market cycle
ensures better performance. Instead, active management
requires talent, low costs, and patience to prosper.6
Our framework considers the impact of four variables
related to these tenets of active management success:
• Gross alpha expectation
• Cost
• Active risk
• Active risk tolerance.
Gross alpha expectation: A judgment about talent
Gross alpha expectation is the anticipation of one’s
ability to achieve successful outcomes. An investor’s
degree of gross alpha expectation about his or her active
manager selection skill is a critical component of the
active allocation decision. It is important to note that
the expectation of alpha does not necessarily translate
into actual alpha—not all decision-makers can be
above average (Sharpe, 1991). Because behavioral biases
such as overconfidence can lead to unreasonable
expectations, a realistic assessment is critical.
Figure 1. Active-passive decision-making during portfolio construction
Note: Illustrations represent a hypothetical efficient frontier based on asset
class expectations and do not represent a particular investment.
Source: Vanguard. Return
Risk
Optimized ef#cient frontier
Return
Risk
a. Select strategic asset allocation based on asset class
expectations (blue dot)
b. Adding active funds adds manager risk. It introduces
idiosyncratic outcomes that could increase or decrease
both the return and risk of the portfolio (purple shading).

5 See Baks, Metrick, and Wachter (2001), Waring et al. (2000), and Waring and
Siegel (2003) for prior research on the active-passive allocation decision process
and methods of addressing investors’ underlying assumptions.
6 For a review of the empirical work done on the lack of systematic outperformance
by investment type, see Davis et al. (2007). For research regarding market periods’
lack of impact on active performance, see Philips (2008) and Philips, Kinniry, and
Walker (2014). For a discussion of what does affect active management success,
see Wallick, Wimmer, and Balsamo (2015a).

Each investor will have his or her own methods of

attempting to identify talented managers and developing
a gross alpha expectation for them.7 This is typically best
done through a rigorous due-diligence process combined
with an understanding of alpha ranges and sensitivity to
the probability of success.
The level of expected alpha is a subjective measurement;
actual future alpha levels are uncertain. In our framework
(as discussed further below), the term “alpha expectation”
carries a statistical meaning; the manager assessment
can be thought of in terms of a distribution or bell curve
of potential alpha outcomes (see Figure 2). The central
tendency or mean of the distribution is the expected alpha,
and its standard deviation is a function of the manager’s
active risk.
Cost: The enemy of net alpha
Evidence shows that the odds of outperformance
increase as investors are able to reduce the cost of
investing in active strategies.8 Indeed, low cost is the
most effective quantitative factor that investors can
use to improve their chances of success.9 The cost
of an active fund is also much more predictable than
gross alpha. Gross alpha expectation and cost combine
to form the net alpha expectation.
Active risk: Uncertainty quantified
Any active fund by its nature deviates from a benchmark
in the attempt to improve returns. No active manager will
outperform the market every day, every week, every
month, or even every year. Even those managers who
have provided successful performance over longer time
frames have typically experienced extended periods of
underperformance.10 This inconsistent pattern of relative
returns can be quantified as active risk (i.e., tracking error),
or the volatility of a fund relative to its target benchmark,
and can be thought of as the uncertainty the investor
attaches to that particular active manager. This is not
to assume that higher tracking error necessarily leads
to higher returns,11 but rather that active funds may take
on a range of different tracking errors.12
When compounded over time through the holding
period of the investment, active risk leads to variation
in performance outcomes that can differ substantially
from the central gross alpha expectation for a manager.
In other words, active risk and gross alpha expectations
both have a straightforward statistical interpretation
in terms of the standard deviation and mean derived
from the bell curve of potential performance outcomes
(see Figure 2).
This distributional interpretation of active manager
skill has been missing in the traditional active-passive
debate, in which a manager’s alpha is typically thought
of in terms of a point forecast. Incorporation of this
distribution is the distinctive feature of our framework.
Active risk tolerance: A proxy for patience
The final element in evaluating the potential use of active
strategies is the degree to which an investor is willing to
take on active risk in the pursuit of outperformance. At
the heart of the active-passive framework is a trade-off
between an investor’s subjective alpha expectation and
his or her subjective tolerance for downside risk, as
depicted in Figure 2. The active-passive decision arises
from balancing the two.
How the variables affect active-passive allocation
Under this interpretation of active-passive allocation
as the solution to the active risk-return trade-off, one
can think of indexing as a diversifier of active manager
risk. Investors uncomfortable about assuming the full

7 Vanguard’s experience with active managers has found that successful

identification of future gross alpha is not based on past performance. Instead,
it is more reasonably based on highly qualitative assessments of the manager’s
people, process, philosophy, and firm. For more on Vanguard’s approach
to selecting managers, see Wallick, Wimmer, and Balsamo (2015a) and Wallick,
Wimmer, and Martielli (2013).
8 See Wallick, Wimmer, and Balsamo (2015b) for further details.
9 For the purposes of this analysis we have assumed indexing is low-cost. Although
not all index funds are low-cost, many market-cap-weighted index funds
are. In addition, although active funds are, on average, higher-cost than the
average index fund, not all active funds are high-cost, and so we consider a range
of expense ratios.
10 Previous Vanguard research has discussed patience as one of the keys to
successful use of active management. Active risk tolerance can also be thought of
as how much patience an investor exhibits regarding fund volatility relative to the
benchmark over time. See Wimmer, Chhabra, and Wallick (2013) for further
discussion of successful active managers’ patterns of returns.
11 See Schlanger, Philips, and LaBarge (2012) for further discussion of this point.
12 This paper uses active risk as the key differentiating characteristic between
fund strategies. History indicates that fund tracking errors have typically stayed
within reasonable bands over time, thus providing a useful barometer for future
expectations. Active share could also have been used to measure funds’ levels
of relative risk, or “activeness.” Although tracking error and active share are
different measures, Vanguard research indicates that they are quantitatively
linked.
We chose to use tracking error because better data are available and investors are
more widely aware of how it’s calculated.

Figure 2. Alpha expectation is a median surrounded by a range of possible outcomes

amount of active risk associated with a given manager

can mitigate the uncertainty by adding more of the
“active-risk-free” asset to the portfolio (see Figure 3).
However, as they do so, any alpha expectation they
had for that manager will also be diluted (i.e., as
shown in Figure 3, the various distributions of portfolio
outcomes become narrower and shift to the left). The
correct allocation is the one that strikes the right balance
between risk and expected active reward. The implication
of Figure 3 is that even when an investor attaches a
positive alpha expectation to a manager, adding some
indexing to the mix can mitigate manager risk.
Before moving on to the quantitative application of this
approach, it’s helpful to consider at a high level how
underlying assumptions for each of our four variables
would influence the allocation, as shown in Figure 4.
Remember that these factors are to be evaluated in
regard to their impact on the active selections being
considered, not the passive alternatives (we know
passive funds have a gross alpha expectation of zero,
can be obtained at a very low cost, and offer relatively
little active risk). The attributes can be thought of in
terms of a sliding scale, each one leading an investor
to lean more toward active or passive.
Were we to stop here, we would be left with a completely
qualitative allocation process. As described so far, the
process outlines the importance of each factor, but it
is incomplete if our goal is to be explicit about how to
weigh one characteristic relative to another. Indeed, any
final decision using solely this approach would be
arbitrarily based on implied assumptions. To avoid
this, we have constructed a quantitative model
that can consider different levels of each of the
decision factors above and better tailor solutions
to specific circumstances.
Figure 3. Indexing can reduce active
manager risk

Figure 4: Key decision factors and their impact on the active-passive mix

From qualitative to quantitative:

A three-step process
Our quantitative simulation framework consists
of three steps:
1. Build simulations for active managers.
2. Calculate the distribution of potential
manager outcomes, including the associated
underperformance risk.
3. Solve for the active-passive allocation that strikes
the right balance between active risk and expected
net alpha.
This framework provides investors with tailored
active-passive allocation targets based on their
inputs and preferences. Next, we’ll describe each
component of the framework and how the three
steps lead to the target allocation.
A quantitative framework for active-passive decisions
The simulation model shown in Figure 5 consists
of three linked components: an active fund universe
simulation, a manager risk calculation, and a risk-return
optimization to find the allocation that best suits the
investor’s attitude toward active risk.
Active manager simulation
The first component, the active manager simulation,
creates a theoretical universe of active mutual fund
outcomes based on inputs of gross alpha expectation,
cost, and active risk. Each combination of these three
variables is used to generate Monte-Carlo simulations
of 10,000 different possible performance paths over
a ten-year period.
We effectively create 45 universes of 10,000 funds
for 45 different investor scenarios: 5 levels of gross
alpha expectation x 3 levels of cost x 3 levels of active
risk = 45 scenarios. These levels and their definitions
are discussed in more detail below.

Figure 5. The quantitative process

Gross alpha expectations of the active fund(s):

Very low, low, neutral, high, very high
Cost (expense ratio) of the fund(s):
Lower, moderate, higher
Active risk (tracking error) of the active fund(s):
Lower, moderate, higher
Manager risk:
10,000 active manager simulations
create a distribution of performance
around alpha expectation
Risk tolerance:
A utililty function solves the risk-return trade-off
for a given level of risk tolerance
Source: Vanguard.
Simulate distributions of potential
outcomes based on gross alpha
expectation, cost, and active risk
1. Active manager simulation
The Monte-Carlo method is a computational technique that uses random sampling to
calculate a number of future scenarios. We
generally sample from historical data or from a user-defined probability
distribution. The potential outcomes become part of a series
of simulations to help summarize a distribution of results.
For Institutional or Accredited Investor Use Only. Not For Public Distribution.

Performance distribution and manager risk

The second component of the model is the manager
risk calculation. It compiles the distributions of each
hypothetical 10,000-fund universe in order to calculate
the range of uncertainty of the funds’ performance.
A simulated distribution of managers with a median net
alpha expectation of zero is illustrated by the bell curve
around the gray line in the center of Figure 5. A sample
distribution of managers with a positive median net alpha
expectation is illustrated by the curve around the purple
line. Although the median for these 10,000 funds is
positive, uncertainty remains, as evidenced by the range
of possible outcomes and the sizable tail risk of those
with a negative net alpha.
Target active-passive allocation
The third component of the quantitative framework
is a utility-function-based calculation. It uses active risk
tolerance to assess the trade-offs between the active
portfolio (represented by a distribution based on net alpha
expectations and active risk) and the passive portfolio
(represented by a single outcome—not a distribution—
based on its relatively low level of active risk). This is
completed for each of the 45 investor scenarios across
3 different active risk tolerance levels, for a total of 135
active-passive allocations.
Utility-adjusted wealth creation over the simulated
ten-year period is calculated for a full range of activepassive
combinations. The suggested allocation is the one
that maximizes utility-adjusted wealth in each of the 135
scenarios. The mathematical process is detailed in Appendix
C. Figure 6 illustrates the sequence of decisions an investor
needs to make when considering an active-passive mix.
Calibrating the simulation parameters
As with all forward-simulation models, our activepassive
calculations are not an assessment of historical
probabilities. Instead we have developed a prospective
framework for decision-making. The range of figures in
each of our scenarios is informed by history but not
reflective of any one particular history.
History is only one of many possible outcomes, and
selective histories will provide different results. We
illustrate a general approach to parameter calibration with
an analysis of U.S. active mutual fund data. We used
asset-weighted, factor-adjusted U.S. active mutual fund
data for the ten years ended June 30, 2016, to calibrate
the ranges for our parameters (five levels of gross alpha
expectations, three levels of cost, three levels of active
risk, and three levels of active risk tolerance).
Two of these parameters—gross alpha expectation (gross
alpha) and active risk (tracking error)—are illustrated in
Figure 7, a visualization of the historical data used to form
the range of inputs used in our case study on page 9.13

Applying the framework to an equity portfolio:

A case study
To further demonstrate how the quantitative approach
can be applied in practice, from here on we will discuss
the framework in the context of an investor determining
a U.S. equity allocation. Although we focus here on one
asset class—U.S. equities—a similar approach could be
applied to a wide range of asset classes.
We conducted our analysis on two levels. Part one
includes gross alpha expectations and cost but excludes
a consideration of how active risk and active risk
tolerance affect the results. Part two accounts for the
uncertainty of active manager performance and varying
levels of investor tolerance to that uncertainty.
Part one analysis: Gross alpha expectation and cost
To determine gross alpha expectation—the expectation of
selecting outperforming active managers—we subdivided
our simulation’s population into five skill levels: very low,
low, neutral, high, and very high. We then quantified
what portion each skill level represented and how these
segments calibrated to recent historical data:
• Very low gross alpha expectation: an expected
random selection from the bottom one-third of the
entire active manager population (which has a median
annualized gross alpha of –1.28%).
• Low gross alpha expectation: an expected random
selection from the bottom two-thirds of the entire
active manager population (which has a median
annualized gross alpha of –0.42%).
• Neutral gross alpha expectation: an expected
random selection from the entire active manager
population (which has a median annualized gross
alpha of 0.16%).
• High gross alpha expectation: an expected selection
from the top two-thirds of the entire active manager
population (which has a median annualized gross alpha
of 0.85%).
• Very high gross alpha expectation: an expected
selection from the top one-third of the entire active
manager population (which has a median annualized
gross alpha of 1.54%)

Notes: Data are for the ten-year period from July 1, 2006, through June 30, 2016,
and represent active equity funds with at least 36 months of history available to
U.S.
investors in the following categories: small-cap value, small-cap growth, small-cap
blend, mid-cap value, mid-cap growth, mid-cap blend, large-cap value, large-cap
growth,
and large-cap blend. Funds that died or merged were included in the analysis. The
oldest and lowest-cost single share class was used to represent a fund when
multiple share
classes existed. Asset-weighted results were calculated using each fund’s average
reported monthly assets. Each fund is represented one time in the figure; because
the
analysis is asset-weighted, the median gross alpha and median tracking error will
not lie in the middle of the ranges for each alpha level and tracking error in the
chart above.
Alpha was calculated by regressing monthly gross returns against the Fama-French
three factors of small minus big, high minus low, and excess return on the market
over the
risk-free rate. Tracking error was measured by calculating the standard error of
the regression.
Source: Vanguard calculations based on data from Morningstar, Inc., and the Kenneth
R. French data library

Cost
The importance of low-cost investment management
has been identified by previous research. On average,
we have found cost to have a negative one-to-one
relationship with excess returns: For every one-basispoint
increase in the expense ratio, subsequent net
excess returns tend to decrease by one basis point, on
average.14 To the extent an investor is subject to taxes,
these are an additional form of cost that can further
affect the odds of successfully using active management.
Active funds tend to have larger tax impacts than marketcap-weighted
index funds, on average.15
Gross alpha expectation addresses gross returns;
however, in the end it is net returns (gross returns less
cost) that matter to investors. In this analysis, we applied
three separate tranches of cost—higher, moderate, and
lower—to the entire population of simulated active funds:
• Higher cost: The median asset-weighted expense
ratio + 0.40% (or 1.19%).
• Moderate cost: The median asset-weighted expense
ratio of 0.79%.
• Lower cost: The median asset weighted expense
ratio – 0.40% (or 0.39%).
Part one results: When alpha and cost are everything
When we run the two critical attributes of gross alpha
expectation and cost through our model (with no
consideration for active risk or active risk tolerance), we
arrive at the results shown in Figure 8. It displays the
outcomes of the 15 scenarios ranging from the lowest
gross alpha expectation and higher-cost active managers
(the top left corner of the grid) to the highest gross alpha
expectation and lower-cost active managers (the bottom
right corner) and calculates the projected allocation ranges
resulting from each set of circumstances.

14 See Wallick, Wimmer, and Balsamo (2015a) and Wallick, Wimmer, and Balsamo
(2015b) for two examples.
15 Although tax costs vary among investors, countries, funds, and timeframes, the
tax costs of active funds have been—in many periods—higher than those of index
funds. See Donaldson et al. (2015) for further discussion. Therefore, an investor
considering the use of low-cost active funds in a taxable account would likely need
to assume a moderate or high level of total cost after taxes, and a taxable
investor using moderate-cost funds would likely need to assume a very high level.
Investors
subject to tax would be well-served by following general principles of taxable
asset location and using active funds in tax-deferred or tax-free (e.g., Roth IRA)
accounts.
Cost
The importance of low-cost investment management
has been identified by previous research. On average,
we have found cost to have a negative one-to-one
relationship with excess returns: For every one-basispoint
increase in the expense ratio, subsequent net
excess returns tend to decrease by one basis point, on
average.14 To the extent an investor is subject to taxes,
these are an additional form of cost that can further
affect the odds of successfully using active management.
Active funds tend to have larger tax impacts than marketcap-weighted
index funds, on average.15
Gross alpha expectation addresses gross returns;
however, in the end it is net returns (gross returns less
cost) that matter to investors. In this analysis, we applied
three separate tranches of cost—higher, moderate, and
lower—to the entire population of simulated active funds:
• Higher cost: The median asset-weighted expense
ratio + 0.40% (or 1.19%).
• Moderate cost: The median asset-weighted expense
ratio of 0.79%.
• Lower cost: The median asset weighted expense
ratio – 0.40% (or 0.39%).
Part one results: When alpha and cost are everything
When we run the two critical attributes of gross alpha
expectation and cost through our model (with no
consideration for active risk or active risk tolerance), we
arrive at the results shown in Figure 8. It displays the
outcomes of the 15 scenarios ranging from the lowest
gross alpha expectation and higher-cost active managers
(the top left corner of the grid) to the highest gross alpha
expectation and lower-cost active managers (the bottom
right corner) and calculates the projected allocation ranges
resulting from each set of circumstances.
10 For Institutional or Accredited Investor Use Only. Not For Public Distribution

Two items are most striking. First, without a positive net

alpha expectation an investor would be better off investing
100% in index funds. Second, without incorporating the
impact of active risk and active risk tolerance, we are left
with a binary choice of either 100% passive funds (when
net alpha expectation is negative) or 100% active funds
(when net alpha expectation is positive).
These simplified conditions result in no recommended
active-passive mix but simply provide a measure of
whether or not positive net alpha is expected. For
example, the box at the intersection of high gross alpha
expectation (0.85%) and moderate costs (0.79%) has
a net alpha expectation of just 0.06% (0.85%–0.79%),
yet the recommendation is all active funds.
An investor concerned about active risk might not
allocate 100% to active funds in this instance. He
or she might well incorporate some portion of index
funds in order to moderate the risk. Part two of our
analysis reflects this reality.
Part two analysis: Net alpha expectations plus risk
considerations
Next, we added risk considerations (active risk level and
tolerance for active risk) to net alpha expectations (gross
alpha minus cost) for our active portfolio to reassess how
the combination influences the active-passive decision.
We divided both active risk and active risk tolerance
into 3 levels by expanding each of the previously
determined 15 pairings (5 different gross alpha
expectation levels x 3 different active risk tolerances)
into an additional 9 subdivisions (3 different levels of
active risk x 3 different levels of active risk aversion)
for a total of 135 possible situations.
Active risk
Taking on active risk is a necessary condition for
producing outperformance but obviously not a guarantee.
We assessed a range of active risk (i.e., tracking error)
for the funds, established three active-risk cohorts, and
showed how these levels calibrated to recent history:16
• Higher active risk: The median of the one-third
of funds with the highest active risk (or 5.12%).
• Moderate active risk: The median of the one-third
of funds with moderate active risk (or 3.45%).
• Lower active risk: The median of the one-third
of funds with the lowest active risk (or 2.41%).
Active risk tolerance
The critical final element is active risk tolerance,
essentially an investor’s ability to handle a given
level of alpha variability through time and willingness
to accept the uncertainty of achieving outperformance.
We used a risk aversion parameter within a utility
function to penalize alpha variability by differing amounts:
• Higher active risk tolerance: a lesser risk aversion
penalty in the utility function.
• Moderate active risk tolerance: a moderate risk
aversion penalty in the utility function.
• Lower active risk tolerance: a greater risk aversion
penalty in the utility function.
The use of a utility function with an embedded risk
tolerance parameter may be an abstract concept to some.
Here, it enables us to quantify different investor risk
preferences for dealing with the uncertainty of active
management, where risk is associated with the alpha
variability of the active portfolio.17
This portion of the analysis allows us to calculate utilityadjusted
wealth (rather than simply total wealth, as we
saw in part one) and understand the risk-driven trade-offs
between active management (which has some degree
of manager uncertainty) and passive management (which
has little manager uncertainty) for a range of active risk
tolerance levels. Without it, the model would produce
only all-or-nothing active or passive allocations

Part two results: When net alpha and risk

considerations lead to a wider range of outcomes
Combining the elements of active risk and active risk
tolerance with gross alpha expectation and cost results
in four variables, each with three different measurement
levels. This 5x3x3x3 structure is illustrated in Figure 9.
All the scenarios for investors with neutral (or worse)
gross alpha expectations remain unchanged from the
part one analysis. If outperformance is the goal, cost,
active risk level, and active risk tolerance do not
supersede the importance of identifying talent.
For those investors with high and very high gross alpha
expectations (the expectation that they will select among
the top two-thirds or one-third of all managers), indexing
still makes up a sizable portion of many allocations. Cost
remains an influencing factor, as does aversion to active
risk. But when higher assumptions for gross alpha are
combined with lower assumptions for cost, active risk,
and active risk aversion, active allocations predominate.
This approach allows us to move from simple binary
solutions of all-active or all-passive investment to a
more nuanced set of results that demonstrates the
trade-off between net alpha expectations and tolerance
for active risk. Furthermore, the quantitative nature of our
framework discloses otherwise embedded assumptions
and enables investors to assess a range of inputs.

Conclusion
Our simulation analysis identifies three overall
conclusions. First, indexing can be a valuable starting
point for all investors. Per our research, a lack of
conviction in identifying active manager talent results
in an all-indexing solution.
Second, it reiterates prior Vanguard research demonstrating
that the use of active management is dependent on
talent, cost, and patience (represented in our analysis by
gross alpha expectation, cost, and active risk tolerance).
The greater an investor’s ability to identify talented active
managers, access them at a low cost, and remain patient
amid the inconsistency of alpha through time, the greater
the suggested allocation to active funds.
Third, investors considering both active and passive
investments will benefit from explicitly identifying
assumptions regarding four key components: gross
alpha, cost, manager risk, and risk tolerance. Because
this tailored approach is based on an investor’s specific
expectations, there will be no one-size-fits-all result.

Notes: Data are for the ten-year period from July 1, 2006, through June 30, 2016,
and represent active equity funds with at least 36 months of history available to
U.S.
investors in the following categories: small-cap value, small-cap growth, small-cap
blend, mid-cap value, mid-cap growth, mid-cap blend, large-cap value, large-cap
growth,
and large-cap blend. Funds that died or merged were included in the analysis. The
oldest and lowest-cost single share class was used to represent a fund when
multiple share
classes existed. Asset-weighted results were calculated using each fund’s average
reported monthly assets. Alpha was calculated by regressing monthly gross returns
against
the Fama-French three factors of small minus big, high minus low, and excess return
on the market over the risk-free rate. Tracking error was measured by calculating
the
standard error of the regression.
Source: Vanguard calculations based on data from Morningstar, Inc., and the Kenneth
R. French data library.

Appendix B: Factor allocations in the active-passive

framework
This paper focuses on alpha expectations, but our
framework can also accommodate the active returns
and risk that result from factor exposures. In that case,
rather than set expectations for gross alpha levels, their
associated active risk levels, and cost, the investor
estimates those variables for factors.18 The due diligence
process for factors has many similarities with the search
for alpha. For example, the investor must:
• Assess the talent of the people designing the strategy
and understand how it’s implemented.
• Have a logical rationale for why the active investment
process will have a reasonable chance of producing
a certain outcome.
• Evaluate to what extent management and various
implementation costs will erode the strategy’s
desired benefit.
• Have the patience to handle sharp and prolonged
periods of underperformance relative to a broad,
cap-weighted index.19
Our framework allows investors to consider alpha and
factor-seeking strategies together to determine the mix
consistent with their goals, beliefs, and circumstances.
A critical step is to assess the combined attributes of
the active allocation when it consists of multiple alpha
or factor strategies. This analysis will reveal whether the
strategies’ aggregate active exposures (their combined
security, sector, factor, country, and regional weights,
for example), reflect the investor’s objectives. If they
do not, it can help determine the trade-offs inherent
in shifting to more suitable weightings.
Finally, as part of ongoing due diligence, the investor
must regularly gauge whether the active results have
been and will likely continue to be driven by the desired
exposures in the most cost-effective way.20
Appendix C: Quantitative approach
to the active-passive decision
Mathematically, the active-passive allocation decision
is the solution to the following optimization problem:
where wA is the allocation to active; rt ~ N(alpha,tracking
error2) is the stochastic return process for the active
manager; rt
is the return of the passive benchmark;
and U (•) is the utility function. The argmax (•) function
solves for the optimal allocation wA corresponding to
the maximum of the average (across 10,000 simulations)
utility/risk-adjusted cumulative portfolio return over the
investment horizon T.
The utility function specification is of the Constant
Relative Risk Aversion type, , where y is
the risk-aversion parameter that measures the level
of active risk tolerance an investor is willing to accept
in the portfolio.

18 For general information on the topic of factor-based investing, see Pappas and
Dickson (2015). For a detailed discussion of important considerations for equity
factor-based investment vehicles, see Grim et al. (2017).
19 This would include any strategy labeled as a strategic or smart beta index,
because by design, the indexes take on active risks by intentionally choosing
weights
that differ from a broad, cap-weighted index. For more information, see Philips,
Bennyhoff, Kinniry, Schlanger, and Chin (2015).
20 For an example of a famous ex post assessment conducted on the Norwegian
Government Pension Fund, see Ang, Goetzmann, and Schaeffer (2009).

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