Here’s a chart of the 15-year cumulative excess return (that is, return above cash) of a long-short fund. Over this period, the fund generated an annualized excess return of 0.82% with an annualized standard deviation of 4.35%. The fund charges 0.66% and many advisors who sell it take a 5.75% commission off the top.

Though its best returns came during the financial crisis, making it a good diversifier, I suspect few would rush out to buy this fund. Its performance is inconsistent, its reward-to-risk ratio of 0.19 is mediocre, and its effective performance fee of 44% is comparable to that of a hedge fund. There are plenty of better-performing market-neutral or long-short funds with lower effective fees.

Despite the unremarkable record, about $140 billion is invested in a version of this strategy under the name of American Funds Growth Fund of America AGTHX. I simply subtracted the Standard & Poor’s 500 Index’s monthly total return from AGTHX’s monthly total return to create the long-short excess return track record (total return would include the return of cash).

This is an unconventional way of viewing a fund’s performance. But I think it is the right way, because, in a real sense, every active fund is a long-short strategy plus its benchmark.

Ignoring regulatory or legal hurdles, a fund manager can convert any long-only fund into a long-short fund by shorting the fund’s benchmark. He can also convert a long-short fund into a long-only fund by buying benchmark exposure on top of it (and closing out any residuals shorts). I could do the same thing to any fund I own through a futures account by overlaying or subtracting benchmark exposure.

Viewing funds this way has three major benefits. First, it allows you to visualize the timing and magnitude of a fund’s excess returns, which can alter your perception of a fund’s returns in major ways versus looking at a total return table or eyeballing a total return chart. Looking at a fund’s three-, five- and ten-year trailing returns tells you precious little about a fund’s consistency and the timing of its returns. The ten-year return contains the five-year return which contains the three-year return which contains the one-year return. (If someone says a fund’s returns are consistent, citing 3-, 5-, and 10-year returns, watch out!) Rolling period returns are a step up, but neither technique has the fidelity and elegance of simply cumulating a fund’s excess returns.

Second, it makes clear the price, historical quantity and historical quality of a fund’s active management. The “quantity” of a fund’s active management is its tracking error, or the volatility of the fund’s returns in excess of its benchmark. The “quality” of a fund’s management is its information ratio, or excess return divided by tracking error. Taking these two factors into consideration, it becomes clearer whether a fund has offered a good value or not. A fund shouldn’t automatically be branded expensive based on its expense ratio observed in isolation. I would happily give up my left pinky for the privilege of investing in Renaissance Technologies’ Medallion fund, which charges up to 5% of assets and 44% of net profits, and I would consider myself lucky.

Finally, it allows you to coherently assess alternative investments such as market-neutral funds on the same footing as long-only active managers. A depressingly common error in assessing long-short or market neutral funds is to compare their returns against the raw returns of long-only funds or benchmarks. A market neutral fund should be compared against the active component of a long-only manager’s returns.

To make these lessons concrete, let’s perform a simple case study with two funds: Vulcan Value Partners Small Cap VVPSX and Vanguard Market Neutral VMNFX. Here’s a total return chart for both funds since the Vulcan fund’s inception on December 30, 2009. (Note that Vanguard Market Neutral was co-managed by AXA Rosenberg until late 2010, after which Vanguard’s Quantitative Equity Group took full control.)

Given the choice between the two funds, which would you include in your portfolio? Over this period the Vanguard fund returned a paltry 3.7% annually and the Vulcan fund a blistering 14.2%. If you could only own one fund in your portfolio, the Vulcan fund is probably the better choice as it benefits from exposure to market risk and therefore has a much higher expected return. However, if you are looking for the fund that enhances the risk-adjusted return of portfolio, there isn’t enough information to say at this point; it is meaningless to compare a fund with market exposure with a market neutral fund on a total return basis.

A good alternative fund usually neutralizes benchmark-like exposure and leave only active, or skilled-based, returns. A fairer comparison of the two funds would strip out market exposure from Vulcan Small Cap (or, equivalently, add benchmark exposure to Vanguard Market Neutral). In the chart below, I subtracted the returns of the Vanguard Small Cap Value ETF VBR, which tracks the CRSP US Small Cap Value Index, from the Vulcan fund’s returns. While the Vulcan fund benchmarks itself against the Russell 2000 Value index, the Russell 2000 is terribly flawed and has historically lost about 1% to 2% a year to index reconstitution costs. Small-cap managers love the Russell 2000 and its variations because it is a much easier benchmark to beat. Technically, I’m also supposed to subtract the cash return (something like the 3-month T-bill or LIBOR rate) from Vanguard Market Neutral, but cash yields have effectively remained 0% over this period.

When comparing both funds simply based on their active returns, Vanguard Market Neutral Fund looks outstanding. Investors have paid a remarkably low management fee (0.25%) for strong and consistent outperformance. Even better, the fund’s outperformance was not correlated with broad market movements.

This is not to say that Vanguard has the better fund simply based on past performance. Historical quantitative analysis should supplement, not supplant, qualitative judgment. The quality of the managers and the process have to be taken into account when making a forecast of future outperformance as a fund’s past excess return is very loosely related to its future excess return. There is a short-term correlation, where high recent excess return predicts high future near-term excess return due to a momentum effect, but over longer horizons there is little evidence that high past return predicts high future return. Confusingly, low long-run excess returns predict low future returns, suggesting evidence of persistent negative skill. If a fund has historically displayed a long-term pattern of low active exposure and negative excess returns, its fees should either be extremely low or you shouldn’t own it at all.

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There’s a puzzle here. Imagine if Vanguard Market Neutral’s managers simply overlaid static market exposure on their fund. Here’s how their fund would have performed.

A long-only fund that has beaten the market by 3.7% a year with minimal downside tracking error over five years would easily attract billions of dollars. But here Vanguard is, wallowing is relative obscurity, despite having remarkably low absolute and relative costs.

Why is this? In theory, the price of active management—in whatever form—should tend to equalize in a competitive market. However, what we see is that long-only active management tends to dominate and is often wildly expensive relative to the true exposures offered, and long-short active management tends to often repackage market beta and overcharge for it, creating pockets of outstanding value among strategies that are truly market neutral and highly active.

I think three forces are at work:

• Investors do not adjust a fund’s returns for its beta exposures. A high return fund, even if it’s almost from beta, tends to attract assets despite extremely high fees for the actively managed portion.
• Investors focus on absolute expense ratios, often ignoring the level of active exposure obtained.
• Investors are uncomfortable with unconventional strategies that use leverage and derivatives and incur high tracking error.

Given these facts, a profit-maximizing fund company will be most rewarded by offering up closet index funds. Alternative managers will offer up market beta in a different form. Active managers that offer truly market neutral exposure will be punished due to their unconventionality and comparisons against forms of active management where beta exposures are baked into the track record.

Investment Implications

When choosing among active strategies, all sources of excess return should be on a level playing field. There is no reason to compare long-only active managers against other long-only active managers. Your portfolio doesn’t care where it gets its excess returns from and neither should you.

However, because investors tend to anchor heavily on absolute expense ratios, the price of active management offered in a long-only format tends to be much more expensive per unit of exposure than in a long-short format. An efficient way to obtain active management while keeping tracking error in check is to construct a barbell of low-cost benchmark-like funds and higher-cost alternative funds.

Gateway (GATEX) is the $8 billion behemoth of the long-short equity mutual fund category, and one of the biggest alternative mutual funds. I’ve long marveled at this fund’s size given its demonstrable lack of merit as a portfolio diversifier. Over the past 10 years the fund has behaved like an overpriced, underperforming 40% stock, 60% cash portfolio. Its R-squared over this period to the U.S. stock market index is 0.85.

Not only is its past performance damning, but little in the substance of the strategy suggests performance will radically change. Gateway owns a basket of stocks designed to track the S&P 500, with a slight dividend tilt. On this portfolio the managers sell calls on the S&P 500, capping the potential upside of the fund in exchange for a premium up front, and simultaneously buy puts, capping the potential downside of the fund at the cost of a premium up front. By implementing this “collar” strategy, the managers protect the portfolio from extreme ups and downs.

There is another way to soften volatility: Own less equities and more cash—which is pretty much what this fund achieves in a roundabout manner.

Portfolio theory says that an investment is only attractive to the extent that it improves the risk-adjusted return of a portfolio. That means three things matter for each asset: expected return, expected volatility, and expected correlation with other assets in the portfolio. The first two are intuitive, but many investors neglect the correlation piece. A low return, high volatility asset can be an excellent investment if it has a low enough correlation with the rest of the portfolio.

Consider an asset that’s expected to return 0% with stock-like volatility and a perfectly negative correlation to the stock market (meaning it moves in the opposite direction of the market without fail). Many investors, looking at the asset’s standalone returns and volatility, would be turned off. Someone fluent in portfolio theory would salivate. Assume the expected excess return of the stock market is 5%. If you own the stock market and the negatively correlated asset in equal measure, the portfolio’s expected excess return halves to 2.5% and its expected volatility drops to 0%. Apply some leverage to double the portfolio’s return and you end up with a 5% expected excess return with no volatility.

In practice, many investors do not assess assets from the portfolio perspective. They fixate on standalone return and volatility. Much of the time this is a harmless simplification. But it can go wrong when assessing alternatives, such as with Gateway. Judged by its Sharpe ratio and other risk-adjusted measures, Gateway looks like a reasonable investment. Judged by its ability to enhance a portfolio’s risk-adjusted return, it falls flat.

I don’t believe individual investors are responsible for Gateway’s size. If anything, institutional investors (particularly RIAs) are to blame. You would think that supposedly sophisticated investors would not fall into this trap. But they do. A large part of the blame belongs to committee-driven investment processes, which dominate institutional money management. When a committee is responsible for a portfolio, they often hire consultants. These consultants in turn promise to help members of the committee avoid getting fired or sued.

In this context, the consultants like to create model portfolios that have predefined allocations to investment types—X% in large growth, Y% in small-cap value, Z% in long-short equity, and so on—and then find suitable managers within those categories. When picking those managers, they tend to focus on return and volatility as well as performance relative to peers. If not done carefully, a fund like Gateway gets chosen, despite its utter lack of diversifying power.

Vanguard is eating everything. It is the biggest fund company in the U.S., with over $3 trillion in assets under management as of June-end, and the second biggest asset manager in the world, after BlackRock. Size hasn’t hampered Vanguard’s growth. According to Morningstar, Vanguard took in an estimated $166 billion in U.S. ETF and mutual fund assets in the year-to-date ending in August, over three times the next closest company, BlackRock/iShares. Not only do I think Vanguard will eventually overtake BlackRock, it will eventually extend its lead to become by far the most dominant asset manager in the world.

With index funds, investors mostly care about having their desired exposure at the lowest all-in cost, the most visible component of which is the expense ratio. In other words, index funds are commodities. In a commodity industry with economies of scale, the lowest-cost producer crushes the competition. Vanguard is the lowest-cost producer. Not only that, it enjoys a first-mover advantage and possesses arguably the most trusted brand in asset management. These advantages all feed on each other in virtuous cycles.

It’s commonly known Vanguard is owned by its mutual funds, so everything is run “at cost.” (This is a bit of a fiction; some Vanguard funds subsidize others or outside ventures.) “Profits” flow back to the funds as lower expense ratios. There are no external shareholders to please, no quarterly earnings targets to hit. Many cite this as the main reason why Vanguard has been so successful. However, the mutual ownership structure has not always led to lower all-in costs or dominance in other industries, such as insurance, or even in asset management. Mutual ownership is a necessary but not a sufficient condition for Vanguard’s success.

What separates Vanguard from other mutually owned firms is that it operates in a business that benefits from strong first-mover advantages. By being the first company to offer index funds widely, it achieved a critical mass of assets and name recognition before anyone else. Assets begot lower fees which begot even more assets, a cycle that still operates today.

While Vanguard locked up the index mutual fund market, it almost lost its leadership by being slow to launch exchange-traded funds. By the time Vanguard launched its first in 2001, State Street and Barclays already had big, widely traded ETFs covering most of the major asset classes. While CEO and later chairman of the board, founder Jack Bogle was opposed to launching ETFs. He thought the intraday trading ETFs allowed would be the rope by which investors hung themselves. From a pure growth perspective, this was a major unforced error. The mistake was reversed by his successor, Jack Brennan, after Bogle was effectively forced into retirement in 1999.

In ETFs, the first-movers not only enjoy economies of scale but also liquidity advantages that allows them to remain dominant even when their fees aren’t the lowest. When given the choice between a slightly cheaper ETF with low trading volume and a more expensive ETF with high trading volume, most investors go with the more traded fund. Because ETFs attract a lot of traders, the expense ratio is small in comparison to cost of trading. This makes it very difficult for new ETFs to gain traction when an established fund has ample trading volume. The first U.S. ETF, SPDR S&P 500 ETF SPY, remains the biggest and most widely traded. In general, the biggest ETFs were also the first to come out in their respective categories. The notable exceptions are where Vanguard ETFs managed to muscle their way to the top. Despite this late start, Vanguard has clawed its way up to become the second largest ETF sponsor in the U.S.

This feat deserves closer examination. If Vanguard’s success in this area was due to one-off factors such as the tactical cleverness of its managers or missteps by competitors, then we can’t be confident that Vanguard will overtake entrenched players in other parts of the money business. But if it was due to widely applicable advantages, then we can be more confident that Vanguard can make headway against entrenched businesses.

A one-off factor that allowed Vanguard to take on its competitors was its patented hub and spoke ETF structure, where the ETF is simply a share class of a mutual fund. By allowing fund investors to convert mutual fund shares into lower-cost ETF shares (but not the other way around), Vanguard created its own critical mass of assets and trading volume.

But even without the patent, Vanguard still would have clawed its way to the top, because Vanguard has one of the most powerful brands in investing. Whenever someone extols the virtues of index funds, they are also extoling Vanguard’s. The tight link was established by Vanguard’s early dominance of the industry and a culture that places the wellbeing of the investor at the apex. Sometimes this devotion to the investor manifests as a stifling paternalism, where hot funds are closed off and “needless” trading is discouraged by a system of fees and restrictions. But, overall, Vanguard’s culture of stewardship has created intense feelings of goodwill and loyalty to the brand. No other fund company has as many devotees, some of whom have gone as far as to create an Internet subculture named after Bogle.

Over time, Vanguard’s brand will grow even stronger. Among novice investors, Vanguard is slowly becoming the default option. Go to any random forum where investing novices ask how they should invest their savings.  Chances are good at least someone will say invest in passive funds, specifically ones from Vanguard.

Vanguard is putting its powerful brand to good use by establishing new lines of business in recent years. Among the most promising in the U.S. is Vanguard Personal Advisor Services, a hybrid robo-advisor that combines largely automated online advice with some human contact and intervention. VPAS is a bigger deal than Vanguard’s understated advertising would have you believe. VPAS effectively acts like an “index” for the financial advice business. Why go with some random Edward Jones or Raymond James schmuck who charges 1% or more when you can go with Vanguard and get advice that will almost guarantee a superior result over the long run?

VPAS’s growth has been explosive. After two years in beta, VPAS had over $10 billion by the end of 2014. By June-end it had around $22 billion, with about $10 billion of that  growth from the transfer of assets from Vanguard’s traditional financial advisory unit. This already makes Vanguard one of the biggest and fastest growing registered investment advisors in the nation. It dwarfs start-up robo-advisors Betterment and Wealthfront, which have around $2.5 billion and $2.6 billion in assets, respectively.

Abroad, Vanguard’s growth opportunities look even better. Passive management’s market share is still in the single digits in many markets and the margins from asset management are even fatter. Vanguard has established subsidiaries in Australia, Canada, Europe and Hong Kong. They are among the fastest-growing asset managers in their markets.

The arithmetic of active management means over time Vanguard’s passive funds will outperform active investors as a whole. Vanguard’s cost advantages are so big in some markets its funds are among the top performers.

Critics like James Grant, editor of Grant’s Interest Rate Observer, think passive investing is too popular. Grant argues investing theories operate in cycles, where a good idea transforms into a fad that inevitably collapses under its own weight. But passive investing is special. Its capacity is practically unlimited. The theoretical limit is the point at which markets become so inefficient that price discovery is impaired and it becomes feasible for a large subset of skilled retail investors to outperform (the less skilled investors would lose even more money more quickly in such an environment—the arithmetic of active management demands it). However, passive investing can make markets more efficient if investors opting for index funds are largely novices rather than highly trained professionals. A poker game with fewer patsies means the pros have to compete with each other.

There are some problems with passive investing. Regularities in assets flows due to index-based buying and selling has created profit opportunities for clever traders. Stocks added to and deleted from the S&P 500 and Russell 2000 indexes experience huge volumes of price-insensitive trading driven by dumb, blind index funds. But these problems can be solved by smart fund management, better index construction (for example, total market indexes) or greater diversity in commonly followed indexes.

Why Vanguard May Not Take Over the World

I’m not imaginative or smart enough to think of all the reasons why Vanguard will fail in its global conquest, but a few risks pop out.

First is Vanguard’s relative weakness in institutional money management (I may be wrong on this point). BlackRock is still top dog thanks to its fantastic institutional business. Vanguard hasn’t ground BlackRock into dust because expense ratios for institutional passively managed portfolios approach zero. Successful asset gatherers offer ancillary services and are better at communicating with and servicing the key decision makers. BlackRock pays more and presumably has better salespeople. Vanguard is tight with money and so may not be willing or able to hire the best salespeople.

Second, Vanguard may make a series of strategic blunders under a bad CEO enabled by an incompetent and servile board. I have the greatest respect for Bill McNabb and Vanguard’s current board, but it’s possible his successors and future boards could be terrible.

Third, Vanguard may be corrupted by insiders. There is a long and sad history of well-meaning organizations that are transformed into personal piggybanks for the chief executive officer and his cronies. Signs of corruption include massive payouts to insiders and directors, a reversal of Vanguard’s long-standing pattern of lowering fees, expensive acquisitions or projects that fuel growth but do little to lower fees for current investors (for example, a huge ramp up in marketing expenditures), and actions that boost growth in the short-run at the expense of Vanguard’s brand.

Fourth, Vanguard may experience a severe operational failure, such as a cybersecurity hack, that damages its reputation or financial capacity.

Individually and in total, these risks seem manageable and remote to me. But I could be wrong.

Summary

• Vanguard’s rapid growth will continue for years as it benefits from three mutually reinforcing advantages: mutual ownership structure where profits flow back to fund investors in the form of lower expenses, first-mover advantage in index funds, and a powerful brand cultivated by a culture that places the investor first.
• Future growth markets are huge: Vanguard has subsidiaries in Australia, Canada, Hong Kong and Europe. These markets are much less competitive than the U.S., have higher fees and lower penetration of passive investing. Arithmetic of active investing virtually guarantees Vanguard funds will have a superior performance record over time.
• Vanguard Personal Advisor Services VPAS stands a good chance of becoming the “index” for financial advice. Due to fee advantages and brand, VPAS may be able to replicate the runaway growth Vanguard is experiencing in ETFs.
• Limits to passive investing are overblown; Vanguard still has lots of runway.
• Vanguard may wreck its campaign of global domination through several ways, including lagging in institutional money management, incompetence, corruption, or operational failure.