A recent three-part article from Morningstar compares American Funds with Vanguard. The first part claims many similarities between the two firms with respect to:

  • Long employee tenure
  • Staid funds
  • Low portfolio turnover
  • Multiple investment managers
  • High diversification
  • Risk aversion
  • Strong market correlations

This is despite all major differences — unlike American Funds, Vanguard

  • Focuses on indexing
  • Sells funds directly to retail investors
  • Has plenty of bonds funds
  • Offers ETFs
  • Services 401(k) plans
  • Is prominently featured in the media

The second part proposes several explanations why, despite those similarities, US equity American Funds have collectively suffered net outflows of $110B, while a single Vanguard Total Stock Market Index (VTSMX) fund gained $45B in net inflows over the trailing three years. Apparently, the main reasons were poor distribution and marketing decisions, and not a poor average fund performance, despite the latter being deficient by an annualized 0.5% vs. VTSMX over the last five years. This indicates that despite a roughly equal performance over the last ten years, and a superior performance over a fifteen-year period, the glory days of American Funds may be over.

The third part delves more into performance and tries to massage the numbers to support the thesis of equality. First, a 25-year time frame of analysis is picked. This is convenient because, as part two shows, the more recent performance of American Funds has been deficient.

Next, seven unidentified American Funds and ten unspecified index funds are chosen for performance comparison. Index funds from firms other than Vanguard are used, apparently to alleviate a low-cost advantage the latter have. Given that the analysis period starts in 1988, only three existing Vanguard index funds are applicable: 500 Index (VFINX), Extended Market Index (VEXMX), and Small Cap Index (NAESX). All these are Investor share class, which means the comparison does not take advantage of even lower cost Admiral shares that were introduced in 2000 (switching between share classes of the same fund is a non-taxable event). With all that, the selection of funds for the comparison is questionable.

Subsequently, a maximum 8.5% front load is applied to American funds. This is fair because an investor could not have purchased these funds without such a load 25 years ago. However, then an “industry standard” 1% fee is charged annually to index funds. This is ostensibly done to account for the lack of “financial advice” with index funds. This “equalization” approach makes no sense because the front load is paid only once, while the financial advice fee is charged annually and thus has a compounding effect. A one-time financial “advice” provided 25 years ago (i.e. “I recommend that you should buy this great fund [on which I get a commission]”) is not the same as continuous advice on asset allocation (typical with passive investments) provided over the 25 year period. Apples to oranges.

Next comes a simplified accounting for taxes, which, for the lack of data, extends the average annual performance penalty for American Funds recorded in the last 15 years to the entire 25-year period. It is unclear if this analysis takes into account the reinvestment of residual after-tax distributions into each fund (this is what an investor would do, absent any external funds to pay taxes). Nevertheless, it is at least an attempt to take an important performance factor into account.

In the end, were it not for the recurring management fee penalty, index funds would have clearly come on top. In addition, this performance comparison does not take into account the volatility of each fund. At a minimum, what were the ex-post Sharpe Ratios for each fund calculated over the entire 25-year period? The article does not say.

In sum, it looks like the article started with a thesis of an apparent equality between the two fund firms, and then concocted a cryptic and incorrect performance analysis to support this thesis. That is regrettable.

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