Morningstar Magazine - August/September 2017 - 13

industry was small, and they were able to exploit
investment niches that rival funds, including
the hedge fund-like mutual funds, failed to pursue.
Hedge funds were the only game in their
small towns, and they profited nicely from that
fact. But those days are gone.
As are hedge funds' excess returns. There is no
mystery to explain, because over the past
decade hedge funds-as measured by indexes
such as the HFRI Fund Weighted Composite
Index-have not been a sure bet against
the mimic mutual funds.2 True, there remain a few
notable exceptions among the hedge funds-
managers who do seem to possess an ongoing
competitive advantage-but the averages relate
a different tale. They reinforce the lesson
that mutual fund industry leader Vanguard has
long taught its shareholders:
Keep it simple, and keep it cheap.
The Loser's Game?
Given their ultimate ascendance, it is surprising
to remember that index funds did not take
the industry by storm. Five years after its debut,
Vanguard 500 Index VFINX had $90 million in
assets, which made it a modest sales success
by the standards of its time, but scarcely
the vanguard of a revolution. Ninety million dollars
was also the total of the industry's indexed assets,
as neither Vanguard nor a rival had launched
a second index fund.

The initial marketing was stymied by the effective,
but misguided, claim made by indexing's
early critics-that index funds always lose. Every
active fund has the chance to beat its costless
benchmark. However, index funds are guaranteed
to trail because they mimic the costless benchmark
but then add expenses (and trading costs). They
lag their benchmarks, every year.
This criticism is largely true, although not entirely.
Expenses do indeed drag down the returns of
index funds when compared with the theoretical
indexes that they track. However, as costs for
the big index funds are slight and there is some

Underperformer?
Vanguard Total Stock Market has outperformed its benchmark only three times over the past 15
calendar years ...
Excess Return
0.4
%

Vanguard Total Stock Market Vs. Wilshire 5000
0.38
0.22

0.16

0.00
-0.08

-0.23

-0.12 -0.02 -0.02 -0.01

-0.05

-0.22

0.0

-0.31

-0.42

-0.4
-0.62

-0.8
2002

2004

2006

2008

2010

2012

2014

2016

... But against real funds, it's been the clear winner.
Excess Return
5
%
4

Vanguard Total Stock Market Vs. Large-Blend Average
4.37
3.25
2.59

3
2.35

1.46

1.30

2.02
1.42

0.80

0.21

2.30
1.60

1.46

0.65

0
-1

-0.59

2002

2004

2006

2008

2010

2012

2014

2016

Source: Morningstar.

fluctuation because the funds' portfolios do not
exactly match the indexes', on occasion
such funds will sneak past their benchmarks.
For example, as the exhibit shows, another
Vanguard index fund, the Admiral share class of
Vanguard Total Stock Market Index VTSAX,
has done so three times in the past 15 years.
The chart would seem to support the early critics.
Total Stock Market has indeed been inferior

to the costless Wilshire 5000 benchmark that it
simulates. (OK, technically, the fund tracked
the Wilshire 5000 until 2005, then for business
reasons switched to a very similar index
provided by the Center for Research in Security
Prices.) In 15 calendar years, Total Stock Market
beat Wilshire 5000 three times, tied once,
and lost on 11 occasions. It didn't trail by much,
to be sure, but it nonetheless did so, and
will just as reliably do so in the future. In addition,

2 Kaissar, N. 2016. "Hedge Funds Have a Performance Problem," Bloomberg.com. March 24.

global.morningstar.com/Morningstarmagazine

http://www.Bloomberg.com http://global.morningstar.com/Morningstarmagazine

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017