Index giant Vanguard lays out the case for — active funds?

It's not usually newsworthy when a mutual fund company rolls out a study extolling the virtues of its active managers. When that mutual fund company is best known for its passively managed investments, however, it's a bit more of an eye-opener. That's why, when The Vanguard Group Inc. recently made the case for its actively managed equity funds in a newly published report, it may have caused some advisers to do a double take. Vanguard, of course, is the largest provider of index funds, which are the antithesis of active management. “We're almost synonymous with indexing, but a quarter of our equity assets are in active funds. Not a lot of people know that,” said Daniel Wallick, principal in the investment strategy group and co-author of the research paper. Passively managed index funds and exchange-traded funds make up the bulk of Vanguard's $2 trillion-plus in assets, but they also have approximately $350 billion in active equity funds. As a group, Vanguard's active equity funds have outperformed their respective benchmarks by an average of 88 basis points a year over the past 10 years, according to Vanguard. Assuming that the average index fund or ETF has an expense ratio in the 15- to 20-basis-point range, the active funds' outperformance jumps closer to a 1% outperformance annualized. The key to the active funds' success, says Vanguard, is finding top talent at a low cost. The low cost focus shouldn't sound new since it's one of the cornerstones of Vanguard's arguments for passive index funds and ETFs. Vanguard's research shows that the lower a fund's cost, the better chance of it beating its benchmark. Mutual funds with the lowest cost, those with expense ratios in the bottom 10th percentile, have beaten their benchmark 32% of the time, while funds with costs in the lowest 50th percentile have beaten their benchmark just 23% of the time. There's also an added twist to Vanguard's active funds. They come with performance fees, which only 3% of all active funds currently have, according to Strategic Insight. The performance fee structure ties a manager's fee to its performance. So the fee is higher when it's outperforming and lower when it's underperforming. Picking a fund with a low expense ratio is only part of the process in selecting the right managers, though. Vanguard knows how tough that can be. The majority of its active funds are subadvised by other asset managers, rather than run in-house. “You can't just look at track records,” Mr. Wallick said. “You need to get beyond the numbers and understand how they operate and why they operate that way.” Mr. Wallick stressed that investing in active funds isn't for the faint-hearted, despite the report's findings. “You have to be comfortable with the variability of returns and willing to hold on over a long time period,” he said. “There's no consistency in alpha. No one should expect that.” Even if you're comfortable with a potential roller coaster ride to benchmark-beating returns, Vanguard's process isn't foolproof. The Vanguard Growth Equity Fund (VGEQX), for example, has 10- and five-year returns that rank in the bottom half of all large-cap-equity funds, according to Morningstar Inc. “You'll have variations in performance,” Mr. Wallick said. “We looked at things on an aggregate basis. Your experience might be very different depending on the fund.” In other words, you may want to stick to an index fund if you're not such a big fan of the rollercoaster.